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Capital Gains Tax: Unmasking the Mystery

If you’re selling any capital asset, you should know that you may be subject to capital gains tax. And according to the Internal Revenue Service, almost everything you own is considered a capital asset, regardless of whether it was purchased as an investment, like stocks or bonds, or for personal use, like your motorhome or your flat screen TV.

If you sell something for an amount that exceeds your “basis” for that item, then the rest is a capital gain and it must be reported as such on your taxes. Your basis is what you spent to get the item, including sales, excise and other taxes and fees, as well as charges for shipping and handling fees, and installation and setup. Also, all expenses you paid for the improvement of an asset, which led to an increase in its value (for example, renovating your rental property), may count towards your basis. In the same manner, your basis will decrease as an asset depreciates.

More often than not, a taxpayer’s home will be exempt from capital gains tax. Most people have their home as their single biggest asset, and if they sell it, they can make a big capital gain, depending on the condition of the market. The good news is some or even all of it may be excluded from the capital gains tax, so long as these conditions are met:

> You owned the home and used it as your main residence for no less than two years within the five-year duration preceding the sale; and

> You haven’t excluded the gain from a previous home sale occurring within two years before the latest sale.

If such conditions are indeed met, you will be able to exclude up to $250,000 from your gain as an unmarried taxpayer, or up to $500,000 if you’re married and filing jointly.

The Effects of Length of Ownership

If the asset you’re selling has been your property for more than a year, the gain you make will be counted as a “long-term” capital gain. If the asset has only been your property for less than a year, it is called a “short-term” capital gain. And taxes for short-term gains are substantially higher than those for long-term gains. If you’ve held an investment for barely a year, the capital gains tax rate is often higher – probably between 10% and 20% or even more.

This tax treatment is one of the specific advantages of applying a “buy-and-hold” investment technique, compared to a strategy that requires continuous buying and selling (day trading, for example). Also, taxpayers in the bottom brackets typically don’t have to pay taxes on long-term capital gains. Hence, the difference between short-term and long-term capital gains could actually mean to pay taxes or not to pay any taxes.

Capital Losses Offsetting Capital Gains

Selling something for less than its basis results in a capital loss. However, only capital losses from an investment – not from the sale of a personal property – can be used to offset capital gains.