Capital Gains – Introduction to Fundamentals

When an individual or business sells an asset, the gain or loss is classified into one of two distinct tax groups – ordinary or capital. The tax classification is strictly tied to the nature of the asset sold. For most businesses, the assets sold are inventory. Inventory is a normal function of the business so therefore any gain or loss is classified as ordinary income.

If the business or individual sells a capital asset, then that gain is classified as a capital gain. To take it one step further, the holding period of the asset sold affects the tax rate applied to the respective gain or loss. If the asset were held less than one year, the gain or loss is treated as ordinary. To treat the gain as capital in nature and therefore take advantage of the reduced capital tax rates, the asset must be held for more than one year.

For the reader to fully understand this article and its respective sections, I encourage the reader to become fully aware of certain terms that will be used throughout. The following terms have a corresponding article explaining this term in more detail:

Capital Asset – any purchase made to acquire or improve property (personal or real), tangible or intangible, that facilitates a change in the taxpayer’s or entity’s financial structure is considered a financial expenditure for tax purposes.
Fixed Asset – any tangible item not consumed within one accounting cycle and provides long term utility is referred to as a fixed asset.
Basis – simply stated, it is the amount the taxpayer pays with after tax dollars for the purchase of the asset.
Accelerated Depreciation – the amount of depreciation in excess of the linear (straight-line) depreciation taken on asset aggregated since the ‘placed in service date’.
At-Risk Rules – a set of tax rules that allow a loss as a deduction against income on the tax return.

This article will first define capital gains and losses and then describe the corresponding tax implications. With this understanding, there are some business issues you will need to understand and then relate them to your respective situation.

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Definition

Whether you sell a ruler or a cargo vessel, the exchange will produce some form of a gain or loss. For tax purposes, the Internal Revenue Service wants to know if the gain or loss is ordinary or capital because it impacts which tax rate you pay. In general, capital tax rates are lower than ordinary rates.

To be classified as a capital gain or loss the asset sold must first be a capital asset. Looking at the ruler, the question is ‘Is the ruler a capital asset?’ In most cases the sales of rulers is actually some form of inventory sale and therefore the gain or loss is ordinary. Officemax can’t claim a capital gain on the asset sold no matter how long that ruler was in the inventory. They are in the business of selling office supplies.

As for the cargo vessel, unless you are the shipyard or some form of a worldwide marine dealership that happens to have cargo vessels in your inventory, then the sale of a cargo vessel is a capital transaction. Think of MAERSK, one of the largest shipping companies in the world. If they sell one of their vessels, the exchange will be a capital sale. They are not in the business of building or dealing cargo vessels.

Now naturally, you are saying to yourself, I get this but I’m not selling a cargo vessel, I selling some kind of asset in my portfolio. Is it ordinary or capital?

To answer this, follow the results of these questions and most of your issues will be resolved:

Are you in the business of selling this particular item or service? If yes, then the transaction is ordinary.
Was the asset sold classed as a fixed asset in your books of record? Then the transaction is capital.
Was the asset purchased with some significant risk of change in value like stocks or financial investments? When sold, this is classed as a capital sale.
Is the asset depreciated or amortized over time in accordance with the tax code? Then when sold, the transaction is capital in nature.
Is the transaction a unique event? Then most likely a capital transaction.

The primary key is the nature of your business, if the product or service is normally conducted as a function of your business, then the transaction is ordinary for tax purposes. Capital based transactions are less frequent, unless it is a high risk financial investment such as stocks, bonds or other insurance based products which are traded regularly.

Now that you are able to distinguish between ordinary and capital as the form of transaction, you will want to understand why this is so important. It relates to the tax implications on the gain or loss.

Tax Implications

Congress has battled over the tax rates for over 100 years. One of the issues relates to the sale of capital assets which are customarily held for long periods of time. In addition, the gain from these sales are typically larger in nature and therefore if taxed at a higher rate, they would drain off significant sums of cash from the taxpayer that could be used for other forms of investment, i.e. stimulate the economy. Let’s take a look at the difference between the two tax rates and their respective impact upon a $1,000 gain on the sale of stock:

Capital Rate of 15% Ordinary Rate of 25%
Tax $150 $250

The difference between ordinary and capital is $100 per $1,000 of gain. There have been numerous studies that illustrate that if the tax rate for capital gains is high or set at the ordinary rates than the aggregated collection of capital gains tax actually goes down. There are all kinds of theories trying to answer this but to me it is pretty obvious, the incentive to conduct a capital transaction is reduced due to the higher tax rate.

Now let’s take a look at this tax implication in a more thorough example which sets the basics for the next tax issue related to accelerated depreciation. This example is the basic concept:

A wealthy young man (sold his technology application) watches the movie ‘FORREST GUMP’. He decides that he wants to be a ‘shrimp boat cap’n’. And so he heads on down to a Louisiana boatyard and offers to buy a boat and he wants it now. The owner looks at him and says ‘Is You Crazy?’ The owner explains to him that it takes a least a year to build a shrimp boat. The young man can’t wait that long and heads off to the shrimp boat docks to purchase an existing boat.

In comes Bubba. Bubba knows everything there is to know about the ‘shrimpen’ business. Bubba purchased a brand new shrimp boat two years earlier and has maintained it well. He even recently had it painted. He paid $500,000 for his new boat and business is good. He is netting (pun intended) around $200,000 per year.

The young man approaches Bubba and says: ‘I’ll buy your boat for $550,000’. Now Bubba isn’t stupid and actually he is wise about the whole industry including boats. In addition, he has gained business savvy over time due to reading and paying attention to his professional help (lawyers and accountants). He knows for him to build a new boat that it will cost $550,000 (inflation) and it will take one year to construct. Thus Bubba will not be able to earn $200,000 in the upcoming year. Furthermore, Bubba thinks about the tax implications; which goes like this:

Since Bubba has a basis of $500,000 in his boat and then sells it for $550,000, Bubba has a gain of $50,000. If this gain is taxed as ordinary, and the tax rate is 25%, Bubba will pay $12,500 in taxes. If the gain is taxed as capital, then the tax will be $7,500. Either way, Bubba will not have enough cash, once he pays the tax, to build a new boat. Bubba consults with his tax advisor and finds out that the tax will be capital. To net $550,000 to build a new boat, Bubba would need to sell the existing boat for $558,824 computed as follows:

Sales Price: $558,824
Basis: 500,000
Gain: 58,824
Capital Gains Tax 8,824 ($58,823 * .15)
Cash Balance: $550,000

Bubba thinks about this for a minute and then realizes he’ll have no income over the course of a year while he waits for his boat to be built if he sells his current boat. It appears appealing but he has his mother and siblings to support. Bubba will also need an additional $200,000 of cash to compensate him for the loss of income. His current income nets him $200,000 and after ordinary taxes at 25%, he actually takes home $150,000 per year. In effect, to be completely neutral in the decision model, Bubba will need $700,000 of cash ($550,000 for the new boat and $150,000 to support his family). Since the $700,000 is attached to his capital asset sale, he wonders how much he sells his boat for in order to net $700,000. Since his basis is $500,000, only $200,000 is the additional amount required and is the actual after capital gains tax. Since the tax is 15% for capital gains, he simply divides the $200,000 by .85 (1 – .15 tax rate) and gets $235,294. Therefore, to break even, Bubba must sell his boat for $735,294 computed as follows:

Sales Price:                  $735,294
Basis:                           500,000
Gain:                           235,294
Capital Gains Tax:         35,294 ($235,294 * .15)
Cash Balance:             $700,000 (Basis of $500,000 + Gain after Tax)

If Bubba sells the boat for $735,294, Bubba will net $700,000 to build a new boat and have $150,000 left over to support his family which matches his net after ordinary tax for his annual earnings.

The above is the basic tax principle involved with capital gains and addressing ordinary tax rates too. When you understand the above, you now have a basic introduction to the concept of capital gain taxes. However, it gets a little more complicated because this is business asset. When you are in business, you are allowed to depreciate the asset over time. This means that a part of the $500,000 investment is taken as a deduction each year for tax purposes, similar to an expense, reducing the overall taxable income. I have an entire series of articles explaining depreciation and if you desire to gain more knowledge go to Accounting Concepts and Principles.

Back in 1986 under the new tax code, Congress authorized the Modified Accelerated Cost Recovery System or commonly referred to as MACRS. This allowed a business asset to use a higher than straight line depreciation allowance. The problem is that straight line depreciation is what is considered reasonable and therefore any gain related to the straight line portion is taxed at the capital gains rate. As an example, let’s assume that the normal straight line for the boat is 20 years and therefore Bubba is allowed $25,000 per year as depreciation. Now remember from our facts above, it has been two years since Bubba purchased the boat. Therefore, Bubba has taken $50,000 of depreciation. His basis is now $450,000 ($500,000 purchase price less $50,000 of depreciation). Since his basis is actually lower, Bubba still needs to cover the cost of a new boat (I’m excluding the income needed for one year in this analysis) which is $550,000. How much must Bubba sell the boat for in order to have a net after tax balance of $550,000? Answer: $567,648 as illustrated below:

Sales Price:                  $567,648
Basis:                           450,000 (He took $50,000 of depreciation)
Gain:                           117,648
Capital Gains Tax:          17,648 ($117,648 * .15)
Cash Balance:             $550,000 ($450,000 Basis + $100,000 Net Gain)

Remember, I said Bubba is a savvy businessman. Under the advice of his accountant, Bubba elected to use MACRS which allowed Bubba to take $50,000 a year as depreciation. However, Congress wrote in the code, that the additional amount over the straight line must be recaptured as ordinary income if you sell your asset prior to the traditional straight line time period. In Bubba’s case he has taken $100,000 of depreciation, $50,000 is the normal straight line portion and another $50,000 is accelerated. The accelerated amount must be taxed at ordinary rates if you sell the asset. Remember, you were not allowed to take this additional amount in your income tax preparation and therefore you would have been taxed on this amount at the ordinary rates. Compare his traditional tax calculation against the savings he made using accelerated depreciation:

Normal Accelerated
Net Income $450,000         $450,000 2 Yrs Before Depreciation
Depreciation 50,000         100,000 2 Yrs of Depreciation
Taxable Income $400,000         $350,000
Tax 100,000             87,500 Tax at Ordinary Rates

Notice that Bubba saved $12,500 in taxes because of the additional depreciation he used under the Code. This is $50,000 of additional depreciation taxed at the 25% rate. He saved this amount of money and that is the primary goal of MACRS. But remember, he has to recapture this amount if he sells his boat prior to the 20 year period.

Now how much must he sell his boat for to net $550,000 for a new boat? Remember, I’m not including the requirement for additional money for his income for one year.

Answer: $582,354 as illustrated below:

Sales Price:                  $582,354
Basis:                           400,000 (He took $100,000 of depreciation; $50,000 straight line & $50,000 accelerated)
Gain:                           182,354
Ordinary Gain:                50,000
Capital Gain:               132,354 (Capital Gain & Ordinary Gain = Total Gain)
Ordinary Tax:                  12,500 ($50,000 * .25 rate)
Capital Gains Tax:          19,854 ($132,354 * .15)
Total Tax:                        32,354 ($12,500 + 19,854)
Cash Balance:             $550,000 ($450,000 Basis + $100,000 Net Gain)

Remember, he is basically paying back his ordinary tax savings due to accelerated depreciation. In addition, he needs to pay the capital gains tax.

Now Bubba can calculate the entire sales price of his boat to pay his ordinary taxes, capital gains taxes and have $550,000 of cash to build a new boat and have $150,000 of cash to support his family for an entire year. The following is the illustration:

Sales Price:                  $758,824
Basis:                           400,000 (He took $100,000 of depreciation; $50,000 straight line & $50,000 accelerated)
Gain:                           358,824
Ordinary Gain:                50,000
Capital Gain:               308,824 (Capital Gain & Ordinary Gain = Total Gain)
Ordinary Tax:                  12,500 ($50,000 * .25 rate)
Capital Gains Tax:          46,324 ($308,324 * .15)
Total Tax:                        58,824 ($12,500 + 46,324)
Cash Balance:             $700,000 ($400,000 Basis + $300,000 Net Gain)

Don’t forget, Bubba needs $550,000 for a new boat and $150,000 of cash to support his family for one year. Thus, for Bubba to break even, the sales price to the young man must be $758,824 or it isn’t worth the trouble and risk to sell the boat. This multi-step example illustrates the complexity involved in capital gains tax and the interaction this tax has with business depreciation. If you understand the above, you have moved into the realm of a sophisticated business entrepreneur as it relates to capital gains.

For accountants, it gets much more complicated related to other forms of assets sold, the various forms of depreciation and the multitude of different recapture taxes that exist. In accounting we refer to the ordinary tax savings that Bubba took due to accelerated depreciation as Tax to Book Timing Differences. But for you, as long as you understand the above concepts, you really don’t need to get into the more complicated forms of recapture. Those sections require a formal education and goes beyond the scope of this website. Suffice it to say, you now have a basic understanding of the fundamentals involved.

Now for some business issues related to capital gains.

Business Issues

Real estate is one of the most interesting aspects related to the rules. Almost everybody believes that when you sell real estate the transaction is a capital transaction. Well, for those of you that own your home and you sell the home, the answer is yes; it is a capital transaction. But some folks are actually in the business of real estate whether as landlords or house flippers or contractors. In their cases, the transaction is ordinary for tax purposes unless they can prove it is a capital transaction. I laugh at those so called professional real estate investors that claim that flipping real estate allows you to take advantage of the tax code. Again, in order to qualify for capital gains treatment, you must either sell a capital asset or not be in the business of selling the item. For those involved in real estate, this is what you normally sell and therefore, you are taxed at ordinary rates on the gains.

Some sales of real estate for a landlord will qualify as a capital sale because of the extensive holding period, i.e. more than one year. But, at the time of sale, many landlords have to address Section 1250 recapture because they use Qualified Non-Recourse Financing to take rental losses at ordinary income tax rates. If you are involved in real estate as a landlord, you should discuss this with your CPA. I do have more information about this subject in my Real Estate Industry Standards section of the website.

The most commonly traded capital asset is stock. These types of transaction are very easy to determine basis and total gain involved. In general, if the stock is sold prior to owning it for one year, then the gain is taxed at ordinary rates. In the past, some investors would sell stock after holding it for one year late in the year to take advantage of the losses for tax purposes and then turn around and purchase the same stock in January. This is referred to as a White Wash transaction. Believe it or not, there are regulations in the Code to prevent this and requires the investor to recapture the loss as ordinary income and the new investment has the same purchase date as the original investment.

You can see the Code has regulations to prevent cheating as it relates to this beneficial tax rate.

For those of you earning less than $75,000 per year, your ordinary rate is equal to 15%. In general, the capital gains tax rate has no real value to you. This is why capital gains tax is referred to as the rich man’s tax. The tax really begins to generate value for those taxpayers making more than $150,000 per year in income.

After reading this article, you should have a good understanding of the following:

The difference between an ordinary transaction and a capital gains transaction
The basic understanding of ‘Basis’
The effect capital gains tax has in your pricing model
An understanding of the ordinary tax recapture when using accelerated depreciation
The difference in straight line depreciation and accelerated depreciation

Congratulations, you made it all the way through and you now have a basic understanding of Capital Gains. Act on Knowledge.