Investors who don’t need annual cash flows from their investments may prefer to invest in assets with the expectation that the investments will appreciate in value over time, providing cash at some point in the future when they sell the assets. Investors also may be willing to assume greater risk in exchange for greater returns than those provided by interest or divi- dend-paying investments. For example, they might purchase raw land, fine art, rare coins, precious gems or metals, growth stocks (stock in corporations that reinvest their earnings to grow the company as opposed to distributing them to shareholders in the form of dividends), mutual fund shares, or even vintage automobiles. Purchasing any such asset is not without risk. Indeed, investments held solely for appreciation potential may actually decline in value.
When taxpayers buy and hold assets with appreciation potential, they typically are investing in capital assets. As we discuss in the Individual Income Tax Overview, Dependents, and Filing Status chapter, capital assets are typically investment-type assets and personal-use assets.17 Thus, artwork, corporate stock, bonds, your personal residence, and even your iPhone are capital assets.
LO 7-2 What if: Assume Courtney (head of household filing status) decides to purchase dividend-paying
stocks to achieve her financial objectives. She invests $50,000 in Xerox stock, which she intends to hold for five years and then sell to fund the Park City home down payment. She invests another
$50,000 in Coca-Cola stock, which she intends to hold for eight years and then sell to fund her son’s education. How much dividend income will Courtney report at the end of the first year if the dividend payments provide an 8 percent rate of return on her investments?16
Answer: At the end of the first year, Courtney will report $4,000 ($50,000 × .08) of dividend income from her investment in the Xerox stock and $4,000 ($50,000 × .08) of dividend income from her in- vestment in the Coca-Cola stock, for a total of $8,000 of dividend income.
What if: Assume Courtney’s ordinary marginal tax rate is 32 percent. How much tax will Courtney owe on her dividend income if the dividends are nonqualified?
Answer: Courtney will owe $2,560 ($8,000 × 32%) of tax if the dividends are nonqualified because the income will be taxed at her ordinary income tax rate.
What if: What amount of tax will Courtney owe if the dividends are qualified? Assume Courtney’s tax rate on qualified dividends is 15 percent.
Answer: Courtney will owe $1,200 ($8,000 × 15%) of tax if the dividends are qualified because quali- fied dividends are taxed at preferential rates.
Example 7-3
16Annual rates of return from dividend-paying stocks are typically lower than the rates of return from taxable bonds. However, it is assumed here that the rates of return are equal for the sake of comparability.
17§1221 defines capital assets in the negative. This code section excludes the following from the definition of a capital asset: inventory, depreciable property or real property used in a trade or business, certain self- created intangibles, accounts or notes receivable, U.S. government publications, certain commodities, derivative financial instruments, certain hedging transactions, and supplies. Self-created patents, inventions, models or designs (whether or not patented), and secret formulas or processes are among the intangibles ex- cluded from the definition of a capital asset.
While it may be enjoyable to view collectible fine art in your home or watch a stock portfolio grow in value on quarterly brokerage statements, from a tax perspective the real advantages of investing in capital assets are that (1) gains are deferred for tax pur- poses until the taxpayer sells or otherwise disposes of the assets,18 and (2) gains gener- ally are taxed at preferential rates relative to ordinary income.19 Why the favorable treatment? One reason is that taxpayers may not have the wherewithal (cash) to pay the tax on their gains until they sell the investment. Another is that the preferential tax rate provides an incentive for taxpayers to invest in assets that may stimulate the economy.
Investors can capture these tax benefits when they sell capital assets at a gain. However, when they sell capital assets at a loss, their ability to deduct the loss may be limited.
When a taxpayer sells a capital asset for more than its tax basis, he or she recognizes a capital gain; if a taxpayer sells a capital asset for less than its tax basis, he or she recog- nizes a capital loss (to the extent the loss is deductible).20 The amount realized or the selling price of a capital asset includes the cash and fair market value of other property received, less broker’s fees and other selling costs. The basis of any asset, including a capital asset, is generally the taxpayer’s cost of acquiring the asset, including the initial purchase price and other costs incurred to purchase or improve the asset.21 Thus, the tax basis of corporate stock purchased from a stockbroker includes the cost of the stock and any additional brokerage fees paid by the taxpayer to acquire the stock. Also, the tax basis in a personal residence includes the initial purchase price plus the cost of subsequent improvements to the home.
TAXES IN THE REAL WORLD So You Want to Invest in Bitcoin
Since 2014, bitcoin usage has increased dramat- ically, averaging over 250,000 transactions per day over the last year (https://blockchain.info/
charts/n-transactions?timespan=1year&daysAver ageString=7). But, what does it mean to invest in bitcoin and what effect does it have on a taxpay- er’s income? Although not the only way, the most common way to invest in bitcoin is to use a buy and hold strategy (called “hodling”). This strategy is profitable when the investor buys low and sells high. The appreciation represents the profit from the investment. Bitcoin is a form of virtual cur- rency, which is a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value” (Notice 2014-21).
Interestingly, the IRS says virtual currency is
“property” and not currency. Therefore, taxpay- ers follow the tax principles that apply to property transactions when determining the income or loss from bitcoin investments rather than treating such income or loss as currency subject to
potential foreign currency gains and losses. For taxpayers holding bitcoin as an investment, any gains or losses are treated as capital.
Keeping in mind that bitcoin is property and not currency for tax purposes is important espe- cially when bitcoin is spent. Bitcoin users have a taxable event each time they purchase goods or services with bitcoin. Each transaction requires the investor to calculate the gain or loss on the disposition of the bitcoin investment, report these gains and losses on Form 8949 and Schedule D (for capital asset transactions), and apply the appropriate tax rate depending on the holding period and the investor’s tax bracket. If the trans- action results in a loss from the bitcoin, the loss will be subject to the capital loss limitations dis- cussed later in the chapter. And remember . . . taxes are paid in dollars, not bitcoin!
Source: IRS Notice 2014-21. https://www.irs.gov/pub/
irs-drop/n-14-21.pdf
18Similarly, interest related to the market discount on bonds and the original issue discount on U.S. EE savings bonds accumulates free of tax until the bonds mature or are sold. However, ordinary rather than capital gains rates apply when the tax must finally be paid.
19Mutual funds that generate current income by regularly selling capital assets or by holding income-producing securities are an exception to this general rule. However, tax-efficient mutual funds that only buy and hold growth stocks are treated more like other capital assets for tax purposes (capital gains are deferred until mutual fund shares are sold).
20As discussed below, losses on personal assets are not deductible for tax purposes.
21Brokers are required to report to the IRS the cost basis of securities their customers sell if the securities were purchased on or after January 1, 2013.
Because taxpayers cannot accurately compute the gain or loss on the sale of a capital asset without knowing its basis, it is important for them to maintain accurate records to track their basis in capital assets. This process is relatively straightforward for unique assets such as a personal residence or individual jewels in a taxpayer’s jewelry collection. However, capi- tal assets such as shares of stock are much more homogeneous and difficult to track.
For example, a taxpayer may purchase blocks of stock in a given corporation at dif- ferent times over a period of several years, paying a different price per share for each block of stock acquired. When the taxpayer sells shares of this stock in subsequent years, what basis does she use to compute gain or loss? By default, taxpayers are required to use the first-in, first-out (FIFO) method of determining the basis of the shares they sell.22 However, if they (or their broker) track the basis of their stock, taxpayers can sell (or in- struct their broker to sell) specific shares using the specific identification method to determine the basis of the shares they sell.23 Taxpayers using the specific identification method can choose to sell their high-basis stock first, minimizing their gains or increasing their losses on stock dispositions.
After Courtney’s car broke down, she decided to buy a new one. To fund the down payment, she sold 200 shares of Cisco stock at the current market price of $40 per share for a total amount realized of
$8,000. Courtney held the following blocks of Cisco stock at the time of the sale:
Cisco Corporation Stock Ownership Holding (1) (2) (1) × (2) Basis of
Period Cost per Share Shares Basis 200 Shares Sold Explanation
5 years $25 250 $6,250 $5,000 FIFO basis
($25 × 200)
2 years $32 250 $8,000 $6,400 Specific ID basis
($32 × 200)
How much capital gain will Courtney recognize if she uses the FIFO method of computing the basis in the Cisco shares sold?
Answer: $3,000. $8,000 amount realized ($40 × 200) minus $5,000 FIFO basis ($25 × 200). As indi- cated in the table above, under the FIFO (oldest first) method, the shares sold have a holding period of five years.
What if: How much capital gain will Courtney recognize if she uses the specific identification method of computing the basis in the shares sold to minimize the taxable gain on the sale?
Answer: $1,600. $8,000 amount realized ($40 × 200) minus $6,400 ($32 × 200). To minimize her gain on the sale under the specific identification method, Courtney would choose to sell the 200 shares with the highest basis. As indicated in the table above, the shares with the higher basis are those acquired and held two years for $32 per share.
Example 7-4
Note in the above example that Courtney receives $8,000 from the stock sale ($40 per share × 200 shares sold) regardless of the method she uses to compute the basis of the shares she sells. The difference between the FIFO and specific identification methods lies in the amount of taxable gain on the current sale. Over time, as taxpayers sell all their stock, both methods will ultimately allow them to fully recover their cost in the investments.
However, applying the specific identification method will result in lower capital gains taxes currently and thereby minimize the present value of the taxes paid on stock sales.
22Reg. §1.1012-1(c)(1).
23Beginning in 2011, brokerage firms are required to report cost basis and type of capital gain (short-term or long-term) on form 1099-B provided to investors. These requirements have phased in over several years and as of 2017, brokerage firms and other financial institutions are required to provide this information for equity securities (including ETFs and RICs) as well as for debt securities.
Types of Capital Gains and Losses
Taxpayers selling capital assets they have held for a year or less recognize short-term capital gains or losses.24 Taxpayers selling capital assets they have held for more than a year recognize long-term capital gains or losses. Short-term capital gains are taxed at ordinary rather than preferential rates. In contrast, long-term capital gains are taxed at preferential rates. However, not all long-term capital gains are created equal. Just like divi- dends, most long-term capital gains are taxed at either 0 percent, 15 percent, or 20 percent, depending on the taxpayer’s filing status and taxable income as shown in Exhibit 7-3. The maximum zero rate amount defines the threshold for the zero percent rate to apply to capital gains. When taxable income is between the maximum zero percent and the maxi- mum 15 percent rate amount capital gains are taxed at 15 percent. These maximum rate amounts are often referred to as breakpoints. When taxable income is above the 15 percent rate amount, capital gains are taxed at 20 percent. However, certain long-term capital gains are taxed at a maximum rate of 25 percent, also known as unrecaptured §1250 gain, while others are taxed at a maximum rate of 28 percent, specifically gain from collectibles and gain from qualified small business stock, for tax policy reasons.
24Nonbusiness bad debt is treated as a short-term capital loss no matter how long the debt was outstanding before it became worthless. Whether a bad debt is considered to be a business or nonbusiness bad debt for in- dividuals depends on the facts and circumstances. In general, if the taxpayer experiencing the loss is in the business of loaning money, the bad debt should be considered to be business bad debt; otherwise, the bad debt will likely be considered nonbusiness bad debt.
What if: Assume Jeb Landers (single), Courtney’s uncle, recently sold a rental home for $160,000. He originally acquired the home many years ago for $100,000, and he has fully depreciated it for tax purposes. Assume that $100,000 of the gain (the unrecaptured §1250 gain portion) is taxed at a maxi- mum rate of 25 percent. If Jeb’s taxable income (before considering this gain) is $210,000, what tax does he owe on the gain if he did not sell any other property during the year?
Answer: $34,000. Because Jeb’s tax basis in the home is $0 (he has fully depreciated it), his gain on the sale is $160,000. Jeb first determines the tax on the portion of the gain taxed at a maximum of 25 percent.
Jeb owes 25 percent tax on the $100,000, resulting in $25,000 of tax on this portion of the gain ($100,000
× 25%) because his marginal tax rate on $210,000 is 35 percent, which is higher than the maximum tax rate of 25 percent for this type of gain. Jeb’s taxable income after including the 25 percent gain is now
Example 7-5
EXHIBIT 7-3
Taxable Income by Filing Status†
Preferential Tax Rates
Married Filing Joint
Married Filing
Separate Single
Head of Household
0%* 0 − $77,200 0 − $38,600 0 − $38,600 0 − $51,700
15%** $77,201 − $479,000
$38,601 −
$239,500
$38,601 −
$425,800
$51,701 −
$452,400
20% $479,000+ $239,500+ $425,801+ $452,401+
†When determining which capital gains tax rate applies, capital gains and qualified dividends that fall within the range of taxable income specified in the table are included in taxable income last.
*The highest income amount in this range for each filing status is referred to as the maximum zero rate amount.
**The highest income amount in this range for each filing status is referred to as the maximum 15 percent amount.
25 Percent Gains When individuals sell depreciable real property held more than one year at a gain, a portion (or even all) of the gain may be taxed at a maximum rate of 25 percent (the unrecaptured §1250 gain portion), and a portion may be taxed as a 0/15/20 percent gain. In the Property Dispositions chapter, we discuss the details of how to compute the amount of 25 percent gain and the amount of 0/15/20 percent gain when an individual sells depreciable real property; however, we include a brief discussion in this chapter because the amount of 25 percent gain affects the capital gain and loss net- ting process we discuss in this chapter.
28 Percent Gains Gains from two types of capital assets are taxable at a maximum 28 percent rate. The first type, collectibles, consists of works of art, rugs or antiques, metals or gems, stamps or coins, alcoholic beverages, or other similar items held for more than one year.25 The second type is qualified small business stock held for more than five years.26 In general,
§1202 defines qualified small business stock as stock received at original issue from a C corpo- ration with a gross tax basis in its assets both before and after the issuance of no more than
$50,000,000 and with at least 80 percent of the value of its assets used in the active conduct of certain qualified trades or businesses. Under this definition, many investors and employees who hold stock in closely held corporations are likely to hold qualified small business stock. When taxpayers sell qualified small business stock after holding it for more than five years, they may exclude a portion of the gain on the sale from regular taxation. Exhibit 7-4 shows the excluded portion of the gain based on the date the taxpayer acquired the stock.
EXHIBIT 7-4 Exclusion for §1202 Stock Held More Than Five Years
Effective Capital
Acquisition Date Exclusion Gains Tax Rate
After September 27, 2010 100% 0%
After February 17, 2009, and before September 28, 2010 75 7 After August 10, 1993, and before February 18, 2009 50 14
The capital gain not excluded from income is taxed at 28 percent. For example, using the minimum exclusion percentage of 50 percent, the effective capital gains tax rate is 14 percent.27
25§408(m).
26§1(h)(7).
27The maximum exclusion is the greater of $10,000,000 ($5,000,000 for married taxpayers filing separately) or 10 times the adjusted basis of the stock [see §1202(b)(1)]. The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) made permanent the exclusion of 100 percent of the gain on the sale or exchange of qualified small business stock acquired after September 27, 2010, and held for more than five years. How- ever, for AMT purposes, taxpayer must add back 7 percent of the excluded gain as a tax preference. Lastly, the excluded gain is not subject to the net investment income tax of 3.8 percent imposed on capital gains (and other investment income) on high-income taxpayers.
$310,000 ($210,000 + $100,000). To determine the capital gains tax rate for the remaining $60,000 gain, Jeb must determine how much of the gain falls within the 15 percent range. Jeb’s 15 percent range is
$38,600 to $425,800. With a starting point of $310,000, adding the $60,000 gain makes his taxable in- come $370,000. Because the entire $60,000 gain is within the 15 percent range, Jeb owes $9,000 of tax on this portion ($60,000 × 15%). In total, he owes $34,000 of tax on the gain ($25,000 + $9,000).
What if: Suppose Jeb’s taxable income is $475,000 rather than $210,000 before considering the gain on the sale of the rental home. What tax does he owe on the gain?
Answer: $37,000. The $100,000 is taxed at 25 percent for a tax of $25,000. The remaining $60,000 of gain is taxed at 20 percent because Jeb’s taxable income including the 25 percent gain ($575,000) places him in the 20 percent rate for long-term capital gains ($425,801+). Consequently, he owes $12,000 of tax on this portion ($60,000 × 20%). In total, Jeb owes $37,000 of tax on the gain ($25,000 + $12,000).
What if: Assume that Jeb (single) sold his stock in Gangbusters Inc., a qualified small business stock, for $200,000 on December 12, 2018. He acquired the stock on November 8, 2010, and his basis in the stock is $50,000. How much tax will he owe on the sale if his ordinary marginal rate is 32 percent?
Answer: $0. Because Jeb held the qualified small business stock for more than five years and because he acquired the stock when the exclusion percentage was 100 percent, he will exclude the entire $150,000 gain from income.
Example 7-6
(continued on page 7-12)