Capital Gains Tax Primer

Capital gains are better than ordinary income for two reasons.  First, you don't pay tax on a capital gain until you sell the asset.  Normally you can choose whether to sell sooner or later, so you control the timing of your gain or loss. For example, you can decide to sell late in December or early in January, depending on which year you want to report your gain or loss. Generally speaking, you don't have that kind of choice with ordinary income, such as interest and dividends. Capital gains have another big advantage over ordinary income: they're taxed at special rates. To qualify for these rates you must have long-term capital gains. Short-term capital gain is taxed at the same rates as ordinary income.

A capital gain or loss is long-term if you held the asset more than one year (at least a year and a day) before you sold it. At that point you're entitled to a special capital gain rate. In most cases the rate will be 20% (10% if the gain falls within the 15% bracket). There are exceptions for certain types of assets.

Note: These rates can lower your taxes, but they never increase your taxes. For example, if you are in the 15% bracket for ordinary income and you have a long-term capital gain that qualifies for the 28% rate, the gain is taxed at your lower 15% rate instead of the special capital gain rate.

The 20% (or 10%) rate should always produce some savings. If your tax bracket for ordinary income is 15%, the rate on this category of capital gain is 10%; if your ordinary tax bracket is 28% or higher, the rate on this category of capital gain is 20%. No matter what your tax bracket is, you get some benefit from qualifying for this capital gain rate.

Measuring Capital Gain
Your capital gain from a sale is measured by the difference between the amount realized in the sale and your basis in the asset you sold. Roughly speaking, the amount realized is what you received on the sale � usually measured by the sale price minus the brokerage commission. Your basis is based on your cost (usually the purchase price plus the brokerage commission) but may be adjusted as a result of various events. For example, if your stock splits while you own it, the basis splits, too.

Example: You buy 100 shares of XYZ at $35, paying $3,500 plus a brokerage commission of $40. Your basis is $3,540. Later, you sell when the stock is at $39. You receive $3,900 minus a brokerage commission of $40, so your amount realized is $3,860. Your capital gain is $3,860 minus $3,540, or $320.

What About Capital Losses? 
If your basis is greater than the amount realized, you have a capital loss.  Capital losses are used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your other income � up to a limit of $3,000 in one year. If your overall capital loss is more than $3,000, the excess carries over to the next year. In other words, you treat the extra portion as if it were an additional capital loss in the following year.

Example: In 1996 Ted had a $4,000 capital gain, and a capital loss of $11,400. He used $4,000 of the capital loss to offset the capital gain: that left a net capital loss of $7,400. He claimed $3,000 of the loss on his 1996 return. The effect was to reduce his taxable income by $3,000. Ted was in the 31% bracket, so the loss decreased his 1996 income tax by $930. The remaining $4,400 of capital loss carried over to his 1997 return. In 1997 he had a $500 capital gain and no capital losses except for the carryover. So he used $500 of the $4,400 carryover to offset the gain, leaving a capital loss of $3,900. Once again, Ted deducts $3,000 of the loss � and carries over the remaining $900 to 1998.

The Wash Sale Rule
The tax law contains rules designed to prevent taxpayers from creating artificial capital losses. One rule you should be familiar with is the wash sale rule. This rule says you can't claim a loss from sale of a security (such as stock) if you buy the identical security as a replacement within the period beginning 30 days before the sale and ending 30 days after the sale. So if you sell XYZ for a loss on December 30 and buy the same stock on January 5 of the next year, you won't get a loss deduction for the sale on December 30. You need to wait at least 31 days to repurchase the stock if you want to claim the loss.

Choose intelligently and you can reduce your tax bite. We aren't suggesting that tax considerations should control your choices. Tax considerations should influence your investment strategy, not control it. If you have a good tax idea that's a bad investment idea, chances are it's not such a good idea. 

Bear in mind that one tax idea may conflict with another one. For example, you may have a choice between selling a stock with a large, long-term gain or another stock with a small, short-term gain. Generally you want to avoid taking the larger gains � but you also want to avoid taking short-term gains. There's no rule of thumb that tells you which tax goal should prevail; you need to do what makes sense overall.  Here are some general strategies:

Minimize Gains by Specifying Costs
You'll pay less tax if you sell shares that have smaller gains (or larger losses). That point may seem almost too obvious to mention when you're comparing two different stocks. But some people need to be reminded that this is also true if you have shares of the same stock that you bought at different prices. In that case you will want to sell specific shares at their higher cost rather than the earlier ones.

Defer gains as long as possible
That's a boring word for a mundane concept: other things being equal, it's better to pay taxes later rather than sooner. So the most basic planning technique for capital gains is simply to avoid selling your gains. Delay until next year and, if possible, until the year after that. The sooner you sell, the sooner Uncle Sam takes his bite. As it happens, this bit of tax strategy is consistent with one of the most successful investing strategies: buy and hold. You save on taxes, you save on brokerage commissions, and if you're holding good quality stocks you're building wealth. Tough to beat that combination.

Avoid Short-Term Gains
 Here's another reason for patience: hold your stocks long enough and the gains will be taxed at a lower rate. Under current law, you need to hold an asset more than a year to qualify for the 20% rate (10% for gain that falls in the 15% bracket). So keep track of your purchase dates and avoid selling stock with gains before you qualify for the lower rate.

Avoid Long-Term Losses
In many cases you are better off if you sell your losers before they turn long-term. Generally this is true only if you have both long-term and short-term capital gains.

Example: During 1999 you have $2,000 of short-term capital gain and $2,000 of long-term capital gain. You also have a stock that has gone down in value by $2,000, and you plan to sell it and report a capital loss. If you sell when the loss is short-term, the loss will zero out your short-term capital gain, which is taxed at the same rate as ordinary income. If you wait until the loss is long-term, the loss will zero out your long-term gain, which is taxed at a more favorable rate.

Soak Up Big Capital Losses
If you have large capital losses and capital gains, it can be helpful if they fall in the same year. That way you don't have a big hit of income � and tax � in one year. You especially want to avoid having your large losses fall in a year after your large gains, because losses carry forward but not back. Remember that you can only deduct $3,000 of capital loss in excess of capital gain.

Example: During 1999 you have $20,000 of capital gain and no capital loss, so you have to pay tax on the entire capital gain of $20,000. During 2000 you have $20,000 of capital loss but no capital gain. You can only deduct $3,000 of the capital loss. The rest carries forward to the next year; it may take several years before you can use it all.

Isolate Long-Term Gains
Except when you're trying to soak up a big capital loss, you generally want your long-term gains to fall in years when you don't have capital losses (short-term losses or long-term losses). Isolating your long-term gains in this way will maximize your use of the favorable rates on long-term gains.

Example: During 1999 you have $3,000 of capital loss (it doesn't matter whether it's short-term or long-term). You also have a $3,000 long-term gain you can take in 1999 or hold until 2000. If you postpone the gain until 2000, your 1999 loss will reduce your tax on ordinary income (wages, interest or dividends, for example), and your gain will be taxed at the favorable rate for long-term capital gain. But if you take your capital gain in 1999 it will swallow up the capital loss and you won't get the benefit of the favorable capital gain rate.