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What You Need to Know about The Capital Gains Tax

written by: Patricia Tokar, CPA•edited by: Laurie Patsalides•updated: 4/24/2009

The capital gains tax rate is generally much lower than the ordinary income tax rates. Channeling your income to be eligible for the capital gains tax rates can dramatically reduce your taxes. 2009 and 2010 may be the perfect years for investing in and selling capital gains property.

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    What is the Capital Gains Tax?

    The capital gains tax is a special rate that is applied to the gains on the sale of certain assets, such as stocks, bonds, real estate, and many other types of property.

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    What Kind of Property Qualifies for the Capital Gains Tax?

    Most property not used in business

    In general, the gain on the sale of any property except property used in business or sold as business inventory, would be classified as a capital gain. There are some exceptions, such as gains on collectibles, certain commodities derivatives and hedging transactions. Even the sale of your car could fall under the capital gains tax, if you sell the car for more than your tax basis in the vehicle.

    Property must be owned for more than a year

    Not all capital gains are taxed at the capital gains tax rates, though. To qualify for capital gains tax rates, it must be considered a long term capital gain, meaning you must have held or owned the property for more than one year before you sold it. Holding the property for even a day less than one year will cause the gain on your sale to be classified as a short term capital gain which will be taxed at ordinary income tax rates.

    Mutual fund distributions

    If you own mutual funds or a real estate investment trust (REIT), your fund may make a capital gain distribution. If so, it will be separated and labeled on your yearly FORM 1099-DIV (Box 2a). You can report this part of your mutual fund income as a long term capital gain and receive the benefit of the capital gains tax, regardless of how long you owned the mutual fund or REIT before receiving the distribution.

    Qualified dividends

    Qualified dividends, (from Box 1b of your Form 1099-DIV) although technically not classified as a capital gain, will also be taxed at the more favorable capital gains tax rates.

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    Capital Gains Tax Rates

    This is where the beauty of the new tax laws can really be seen. Current capital gains tax rates are based on your level of taxable income. If you fall in the lower tax brackets, you may pay no tax at all on your long term capital gains. Yes, that’s zero. In 2008, a married couple could have up to $65,100 in taxable income and still qualify for the zero tax.

    For the sale of most non-business assets, the long term capital gain taxes are 0% for those in the 10% and 15% tax brackets. The rate is 15% for all other tax brackets.

    Depreciable real estate (such as a rental property) is a little more complex to calculate but some of the long term gain may still qualify for the capital gains tax rates. Depreciation must first be recaptured, excess depreciation over the straight-line method must also be calculated, and any gain still remaining after these adjustments is calculated. All three of these pieces would potentially have a different tax rate.

    Collectibles have their own calculation and a maximum capital gains tax of 28%.

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    Reporting Capital Gains

    Capital gains are reported on Schedule D of Form 1040. The capital gain tax is calculated with a (rather tedious) worksheet that accompanies Schedule D.

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    Planning When to Sell

    If you are planning to sell a capital asset, you can dramatically reduce your taxes on the gain if you wait at least a year after purchase of the asset before selling it.

    You may also want to consider selling your capital asset before the end of 2010. Unless there is new legislation, these capital gains tax rates will expire for tax years starting after 2010.

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    Legal Stuff

    This article is not intended to be specific tax advice. It is intended as a general guideline only. Any specific advice should be sought from your tax professional.

    CIRCULAR 230 DISCLOSURE: Pursuant to Treasury Department guidelines, any federal tax information contained in this article, or any attachment, does not constitute a formal tax opinion. Accordingly, any federal tax advice contained in this communication, or any attachment, is not intended or written to be used, and cannot be used, by you or any other recipient for the purpose of avoiding penalties

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