A capital asset generally means any property except:
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Inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business;
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Depreciable or real property used in the taxpayer's trade or business;
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Specified literary or artistic property;
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Business accounts or notes receivable; or certain U.S. publications.
In most instances, a gain or loss on the sale of an asset is not recognized for income tax purposes until the taxpayer disposes of the asset. When any gain becomes taxable, moreover, it may be eligible for the preferential capital gains tax rates depending on the length of time the assets were owned.
Holding Periods
Under the previous Code, there were only two capital gains holding periods: 12 months or less; and over 12 months (then considered "long term"). Under the new Act, there are four holding periods:
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Short term - 12 months or less;
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Mid term - over 12 months, but not over 18 months effective for all sales on or after July 29, 1997);
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Long term - over 18 months, but not over five years effective for all sales on or after July 29, 1997); and
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Over five years (becomes effective on January 1, 2001).
Capital Gains Tax Rates
Prior to the Taxpayer Relief Act of 1997, capital gains held for more than 12 months were taxed as ordinary income, but not to exceed 28%; i.e., the minimum capital gains tax rate was 15%, and the maximum capital gains tax rate was 28%.
Under the new Act and current marginal tax rates, capital gains tax rates will range from a low of 10% to a high of 39.6% (8% to 39.6% effective January 1, 2001), and are based as follows on the four holding periods just discussed.
Short Term Gains. Short term gains are taxed at the taxpayer's ordinary income tax rates-currently 15%, 28%, 31%, 36%, or 39.6%.
Mid Term Gains. Mid term gains are taxed at the taxpayer's ordinary income tax rates, but not to exceed 28%; Le., a minimum tax of 15% and a maximum tax of 28%.
Long Term Gains. Long term gains of taxpayers in the 15% marginal tax bracket are taxed at a maximum rate of 10%. Long term gains of taxpayers in marginal tax brackets of 28%-and-higher are taxed at a maximum rate of 20%.
Five Year Gains. Gains on the sales of assets held for more than five years may be taxed at even lower rates beginning January 1, 2001:
8%on assets sold on or after January 1, 2001 by taxpayers in the 15% marginal tax bracket;
18% on assets both purchased and sold on or after January 1, 2001 by taxpayers with marginal tax brackets of 28%and-higher; and
20% on assets purchased before January 1, 2001 but sold after that date by taxpayers with marginal tax brackets of 28%-and-higher.
CAPITAL GAINS HOLDING PERIODS AND TAX RATES
CATEGORY |
HOLDING PERIOD |
EFFECTIVE DATE |
MINIMUM TAX RATE |
MAXIMUM TAX RATE |
|
|
|
|
|
SHORT TERM |
12 MONTHS OR LESS |
MAY 7,1997 |
15% |
39.6% |
LONG TERM |
OVER 12 MOs, BUT NOT OVER 5 YEARS |
JULY 29, 1997(1) |
10% |
20% |
FIVE YEAR |
OVER 5 YEARS |
JANUARY 1, 2001 |
8% ( 2) |
18% (3) |
DEPRECIATION RECAPTURE (4) |
N/A |
MAY 7, 1997 |
15% |
25% |
(1) SALES ON OR AFTER MAY 7,1997 BUT BEFORE JULY 29,1997 QUALIFY FOR THE 10% AND 20% TAX RATES PROVIDED THE ASSETS WERE HELD FOR MORE THAN 12 MONTHS(2) ON ASSETS SOLD ON OR AFTER JANUARY 1, 2001 BY TAXPAYERS IN THE 15% MARGINAL TAX BRACKET(3) ON ASSETS BOTH PURCHASED AND SOLD ON OR AFTER JANUARY 1, 2001 BY TAXPAYERS WITH MARGINAL TAX BRACKETS OF 28% - AND - HIGHER(4) THESE RATES ARE APPLICABLE FOR REAL PROPERTY ONLY (RATES ON DEPRECIATION RECAPTURE FOR ALL OTHER CAPITAL ASSETS ARE 10% AND 20%). FOR OWNERS OF PRIMARY RESIDENCES, ONLY DEPRECIATION TAKEN ON OR AFTER MAY 7,1997 MUST BE RECAPTURED. FOR INVESTMENT PROPERTY OWNERS, ALL DEPRECIATION TAKEN‑REGARDLESS OF DATE‑MUST BE RECAPTURED AT THESE RATES.
Special Capital Gains Tax Rules
Sales Prior to May 7, 1997. All sales prior to May 7, 1997 are subject to the previous holding periods and capital gains tax rates; i.e., "long term" means a holding period exceeding 12 months, and gains are taxed at a minimum rate of 15% and a maximum rate of 28%.Sales on or After May 7, 1997 But Prior to July 29, 1997. Sales on or after May 7, 1997 but before July 29, 1997 qualify for the new 10% and 20% capital gains tax rates, provided the assets were held for more than 12 months.
Collectibles
Gains from the sales of collectibles are still taxed at the same 15% and 28% rates as before. The Tax Code defines collectibles as;
Although the above items are ordinarily of no interest in a real property transaction, they may enter in to the sale of a business. The Act specifies that any gain from the sale of an interest in a partnership, S‑corporation, or trust which is attributable to appreciation in the value of collectibles will be treated as gain from the sale of a collectible.
In other words, while the majority of gain from the sale of a business may be taxed at the preferable 10% and 20% rates, that portion of the gain attributable to the value of collectibles may be taxed at the 15 % and 28 % rates!
Depreciation Recapture on Investment Properties
For sellers of investment real property, any gain attributable to depreciation is taxed at a minimum rate of 15% and a maximum rate of 25%. By comparison, gains attributable to depreciation taken on assets other than real estate are taxed at the more‑favorable 10% and 20% rates. Consequently, the real estate industry is correct when it notes that real estate has been treated unfairly in this regard.
For taxpayers with marginal tax brackets of 28%‑and‑higher, however, these new rates are preferable to the previous regulations: any gain resulting from straight‑line depreciation on real estate was taxed at a maximum rate of 28%; and any gain resulting from accelerated depreciation was taxed at the taxpayer's ordinary marginal tax rates (15 % - 3 9.6 %).Unlike the tax treatment of a primary residence used partially for business, all depreciation taken on an investment property‑even that claimed prior to May 7, 1 1997-must be recaptured and taxed at the 15% and 25% rates.
As before, the tax obligation on depreciation calculated by the straight-line method may be spread over the term of an installment sale; the total tax obligation on depreciation calculated by the accelerated method, however, is still due in the year of sale, even if the property is sold on an installment basis.
Installment Sales of Businesses
Public Law 106-170, entitled the Ticket to Work and Work Incentives Improvement Act of 1999, was enacted on December 17, 1999 to extend certain tax benefits that otherwise would have expired. To offset the revenue lost to these benefits, Public Law 106-170 among other things repealed the ability of an accrual basis taxpayer to use the installment method when reporting the profit on the sale of a business. This repeal became effective for sales of businesses on or after December 17, 1999. The change is not retroactive to sales taking place before that date. A cash basis taxpayer may continue to use the installment method when reporting resale profits.
ACCRUAL VS. CASH BASIS ACCOUNTING
For purposes of accounting, the accrual basis reports income and expenses in the period they are earned or incurred, regardless of whether the business actually receives or disburses cash during that period. By way of example, a business that invoices a customer in June for the purchase of a product is deemed to have earned the income in June even if payment is not received until July. Likewise, a bill received in June is deemed to be a June expense even if the bill is not paid until July. By contrast, the cash basis of accounting records income and expenses in the period they are actually received or disbursed. Most businesses use the accrual accounting method-in fact, the tax code requires a business to use the accrual method if it maintains inventories.
Installment Sales
Under the installment method, a seller who finances the sale of an asset may ordinarily pay the tax obligation on profit over the period of time the purchase price is actually collected. For example, if the profit is determined to be 25 percent-of the asset's sale price,-25-percent of the principal received each year is taxable over the entire life of the seller financing. Advantages of the installment method include the ability of:. A seller to get a higher price for the business;
. A seller to transfer profits into future tax years when the seller earns less income and moves into a lower tax bracket;
. A buyer to purchase a business that normally would not qualify for bank financing;
. An owner's children, who are just getting established in their careers, to purchase their parent's interest.
EFFECT ON ACCRUAL BASIS TAXPAYERS
By repealing this ability, an accrual basis taxpayer is now obligated to pay the entire tax on profit in the year of the sale, even if the tax obligation exceeds the down payment received. As a result of the new law, many business transactions have already fallen apart because buyers have found it uneconomical to pay the full purchase prices in cash. Alternatively, in those transactions that have been completed, sellers have been forced to take substantial cuts in sales prices to persuade buyers to pay the purchase prices in cash.
January, 2001- Two bills-S. 2005 and H.R. 3594-have been introduced to repeal this change, but both are currently stalled in committee. Amending language has also been added to a third bill, H.R. 3081, which proposes to raise the minimum wage and at the same time provide tax benefits for small businesses.
Installment sale payments received on or after May 7, 1997 are generally eligible for the lower capital gains tax rates of 10% and 20%, even though the sale took place earlier.
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