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The Mystery of Capital Gains Tax

If you’re selling any capital asset, you should know that you may be subject to capital gains tax. And the Internal Revenue Service says nearly everything you own is counted as a capital asset, whether you purchased it for personal consumption (for example, your car or your flat screen TV) or as an investment (for example, stocks or real estate).

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, if you paid to improve an asset and increase its value (for instance, renovating the bathroom in your rental property), those expenses can be added to 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. For most people, their biggest asset is their home, and selling it would mean that they can make a huge capital gain, depending on the market’s condition. The good news is you can exclude a part or even all of such a gain from the capital gains tax, provided the following conditions are met:

> You owned the property and used it as your primary residence for at least two years within the five-year period prior to the sale; and

> You haven’t excluded the gain from a past home sale that happened with two years prior to the latest sale.

If these conditions are actually met, you can have up to $250,000 excluded from your gain if you’re unmarried and $500,000 if you’re married and filing jointly with your spouse.

How Length of Ownership Matters

Selling an asset you have owned for over a year, your gain will be considered a “long-term” capital gain. If your length of ownership is less than a year, it is considered 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). In addition, taxpayers in the lowest brackets often need not pay any tax on long-term capital gains. In other words, between short-term and long-term capital gains, the difference could actually mean that a person will pay taxes or will not pay any taxes at all.

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.

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