Understanding the Tax Reporting Rules of Capital Gains and Losses

Ed Zurndorfer explains the tax reporting rules of capital gains and losses related to investment assets

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Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.

The net capital gain or loss resulting from all of an individual’s capital asset sales and capital gains distributions that the individual received during 2020 should be reported on the individual’s 2020 Form 1040, line 7. Schedule D is used to report and summarize the specific capital asset sales and capital gains distributions. This column explains the tax reporting rules for individuals who incurred capital gains and losses during 2020.

What is a “Capital Asset”?

Internal Revenue Code (IRC) section 1221 defines a “capital asset” as everything owned by an individual for: (1) investment purposes (this includes stocks, bonds, open-ended [mutual] funds, closed-end funds, and exchange-traded funds); (2) personal use (this includes primary and secondary/vacation home residences and furnishings, vehicles, jewelry, tools, computers, paintings); (3) pleasure purposes (this includes recreation vehicles, time-shares, athletic equipment, coin or stamp collections); and (4) business purposes.

Net gains resulting from investment capital asset sales are taxable while net losses are potentially tax deductible. But net gains resulting from personal and pleasure capital assets sales are always taxable while net losses from such sales are never tax deductible.

What is Not a “Capital Asset”?

According to IRC Section 1221, the following items are not considered as capital assets: (1) inventory held mainly for sate to customers; (2) depreciable property used in a trade or business; (3) personally created copyrights, musical or artistic compositions; and (4) business accounts and notes receivable.

Holding Period

Capital gains and losses must be separated according to how long a sold capital asset was held (owned) by the capital asset owner. The following summarizes the holding period rules for capital assets:

• Short-term. The holding period is one year or less.
• Long-term. The holding period is more than one year.

To determine a capital asset’s holding period, a capital asset owner should begin counting the holding period on the day after the capital asset is acquired, including the date of disposition. There are exceptions, namely: (1) property that is acquired by inheritance and is treated as long-term property; regardless of how long it was actually held; and (2) a nonbusiness bad debt must be treated as a short-term capital loss.

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For a security (for example – stocks, bonds, closed-end funds, exchange-traded funds traded on an established securities market), the holding perioding begins the day after the “trade date” the security is purchased and ends on the “trade date”, the day the security is sold. Note that the “trade date” is different than the “settlement date”, which is the date the security purchaser must make payment for the purchase of the security. The following example illustrates:

Peter purchases 50 shares of XYZ stock (which is traded on an established securities market), that has a trade date of Jan. 28, 2019. In order to qualify for the long-term holding period, Peter would have to sell the XYZ stock with a trade date on or after Jan. 30, 2020.

Capital Gains Tax Rates

For 2020, the long-term capital gains tax rates are 0%, 15%, 20%, 25% and 28%. For purposes of discussing the capital gains tax rates on investment capital assets, only the 0%, 15% and 20% taxes apply.

The Tax Cut and Jobs Act of 2017 (TCJA) retained the 0%, 15% and 20% rates on long-term capital gains and qualified dividends for individuals. However, for the period 2018 through 2025, these three tax rates have their own brackets that are not tied to the ordinary income (marginal) tax brackets. This means that the breakeven points for the preferential capital gain rates no longer coincide with ordinary income tax brackets. The following table summarizes 2020 income brackets for long-term capital gains and qualified dividends:

Table 1. Tax Filing Status/Taxable Income Limits¹ for Long-Term Capital Gains and Qualified Dividends

Long-Term Capital Gain Tax Rate1	Single	Married Filing Joint	Head of Household
0%	$0 to $40,000	$0 to $80,000	$0 to $53,600
15%*	$40,001 – $441,450	$80,001 – $496,600	$53,601 – $469,050
20%*	$441,451 and over	$496,601 and over	$469,051 and over

The following table summarizes 2020 income brackets for ordinary income:

Table 2. Tax Filing Status/Taxable Income Limits¹ for Ordinary Income

Ordinary Income Tax Rates1	Single	Married Filing Joint	Head of Household
10%	$0 to $9,875	$0 to $19,750	$0 to $14,100
12%	$9,876 to $40,125	$19,751 to $80,250	$14,101 to $53,700
22%	$40,126 to $85,525	$80,251 to $171,050	$53,701 to $85,500
24%	$85,526 to $163,300	$171,051 to $326,600	$85,501 to $163,300
32%	$163,301 to $207,350	$326,601 to $414,700	$163,301 to $207,350
35%	$207,351 to $518,400	$414,701 to $622,050	$207,351 to $518,400
37%	$518,401 and over	$622,051 and over	$518,401 and over

        Short-term capital gain tax rates use ordinary income tax brackets which are slightly higher than the above table.

The following are the rules by which the capital gains tax rates are applied:

• Capital gains and losses are divided into two categories: Short and long-term.
• Capital assets held short-term and sold at a gain or loss are taxed as follows:
  • Multiple short-term asset sales are combined with gains and losses netted to produce a net short-term gain or loss
  • Net short-term gain is taxed as ordinary dividends short at ordinary income tax rates
  • Net short-term loss is netted against any net long term capital gain; if none, then deductible (reduce other income) up to $3,000 per year, and any excess short-term capital loss is carried forward to future years without expiration

• Capital assets held long-term and sold at a gain or loss are taxed as follows:
  • Multiple long-term asset sales are combines with gains and losses netted to produce a net long-term gain or loss
  • Net long-term loss is netted against any net short- term capital gain; if none, then deductible up to $3,000 per year, and then carried to future years without expiration
  • Net long-term gain on most investment capital assets is taxed at preferential long-term capital gain rates (0%, 15% or 20%)

• Both short- and long-term losses are combined within a year in order to limit the total deductible capital loss to $3,000 per year, after offsetting against short- and long-term capital gains.
• A capital loss sustained by a decedent in the year of death (or carried over to that year from an earlier year) can be deducted only on the final tax return for the decedent. The capital loss limits still apply in this situation. The decedent’ estate cannot deduct any of the loss or carry it over to the following years.

• Property received as a gift usually uses the gift donor’s adjusted basis, and the holding period is considered to have started on the same day the donor’ holding period started, but:
  • If the fair market value of the capital asset at the time of the gift is less than the donor’s adjusted cost basis, the gift donee’s cost basis (for the purpose of determining a gain or loss when selling the capital asset) depends on whether the donee would have a gain or loss if the donee were to sell the capital asset. If the donee were to incur a capital gain if he or she were to sell, the donee’s cost basis for calculating a capital gain is the same as the donor’s adjusted cost basis, plus or minus any required adjustment to the cost basis while the donee held the property. If the donee were to incur a loss if he or she were to sell, then the donee’s cost basis for calculating a capital loss is the fair market value of the capital asset when the donee received the capital asset plus any required adjustment to the basis while the donee held the capital asset. The following example illustrates:

These are hypothetical examples for illustration purpose only and does not represent an actual investment.

Henry receives as a gift 100 shares of the XYZ stock. At the time of the gift, the 100 shares had a current value of $8,000. The donor’s adjusted cost basis of the stock was $10,000. After Henry received the stock, there was no increase or decrease in the value of the XYZ stock. If Henry were to sell the 100 shares of the XYZ stock at $12,000, he would have a capital gain of $2,000 ($12,000 less $10,000) because Henry must use the donor’s adjusted cost basis ($10,000) at the time of the gift to calculate the capital gain. If Henry were to sell the 100 shares for $7,000, then Henry will have a $1,000 capital loss because he must use the fair market value of the 100 shares at the time he received the gift ($8,000) as his cost basis to calculate a loss.

If the sales price is between $8,000 and $10,000, then Henry would have neither a capital gain nor a capital loss.

Finally, in reporting the sale of capital assets on Schedule D, individuals should be aware of a potential tax trap. Even if an individual meets the income limits, only a portion of the capital gains may qualify for the zero-percent tax rate. That is because the capital gain income resulting from the sale of an individual’s investment capital assets is added to the individual’s other (ordinary) income, resulting in additional taxable income for the purpose of determining the individual’s ordinary tax bracket. The following example illustrates:

George and Sarah are a married couple filing joint and whose taxable income consists of retirement income and capital gains. During 2020, George and Sarah’s taxable retirement income totaled $50,000 and their capital gain income totaled $30,000 for a total taxable income of $80,000. As shown above in Table 2 above, for a married couple filing joint, the 12% marginal tax bracket ends at $80,250 of taxable income. This means that since George and Sarah are in a 12% tax bracket, all of their capital gain income will be taxed at 0%.

If George and Sarah’s capital gain income for 2020 totaled $40,000, then their total 2020 taxable income would be $50,000 plus $40,000, or $90,000.  $90,000 less $80,250 is $9,750. This means that of George and Sarah’s total capital gain income of $40,000 during 2020, $30,250 will be taxed at 0% and $9,750 of the capital gain income would be taxed at a long-term capital gains tax rate of 15%.

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