Capital Gains Tax - Introduction

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Capital Gains Tax - Introduction

• - Capital gains tax applies whenever an asset is
  sold for a profit.
• - A capital gain is the sale price minus the
  taxpayers adjusted basis.
• - The basis starts at the price paid for the
  property and then
• ADD the amount that was put into improving the
  property and
• SUBTRACT the amount, if any, that the taxpayer
  has written off based on depreciation
• - Short term capital gains (within one year of
  purchase) are taxed as ordinary income
• - Long term capital gains are taxed at a lower
  rate.

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Capital Gains Tax on Partial Sales

• If a person sells part of a property, the basis
  for that portion of the property is generally the
  percentage of the whole basis that is
  proportional to its value relative to the whole
  property.
• In numbers, you use this simple formula to
  determine the basis of the portion sold
• the total basis of the property x value of
  the sold portion
• 
  total value of the property

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Capital Gains Tax on Partial Sales - Example

• Jenny buys 500 shares of Big Co, Inc. for 20,000
  in 2003.
• In 2008, Jenny sells 200 shares for 50,000.
• What is her basis for the 200 shares?
• What is her capital gain?

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Capital Gains Tax on Partial Sales - Solution

• The total basis for the property was 20,000 and
  she sold 2/5 of her shares. Therefore, her basis
  for the shares that she sold is 8,000.
• Since her basis for the shares that she sold is
  8,000 and her sales price is 50,000, Jennys
  capital gain is 42,000.

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Annuities

• An annuity is an arrangement whereby the
  annuitant pays a sum in exchange for fixed
  payments over the next years. The number of
  years can be fixed or it can be for the rest of
  his or her life. In the latter case, the payment
  will be based on the life expectancy of the
  annuitant.
• Income Tax Treatment
• Each repayment is considered part return of
  principal (not taxed) and part income (taxed).
• The amount thats considered income is the amount
  over and above the pro rated share of the
  principal that is scheduled to be paid back as
  part of the annuity payment each year. (For
  lifetime annuities, use the life expectancy.)

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Annuities - Example

• Carla pays 300,000 in exchange for an annuity
  that will pay her 30,000 per year for the next
  15 years. How much of the 30,000 annual payment
  is income?
• Answer Over the course of the annuity, it will
  pay Carla a total of 450,000 (15 years x
  30,000). Therefore, 2/3 of the total amount
  will be return of principal and 1/3 income.
  Therefore, each year 10,000 of the annuity
  payment will be taxed as income.
• Note that if Carla were 70 years old and had a
  life expectancy of 15 years under the IRS tables
  and the annuity were for the rest of her life,
  the same result would apply.

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Life Insurance Proceeds

• - Life insurance payouts that are made because
  the insured died are NOT taxable as income to the
  recipient
• UNLESS
• The recipient is someone without an insurable
  interest in the decedent. In such a case, the
  recipient is considered an investor and his
  profit is taxed as ordinary income.
• - For whole life policies, if one withdraws cash
  value of the policies, it is not considered
  income unless and until the amount withdrawn from
  the policy exceeds the total amount of premiums
  paid.

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Other Miscellaneous Rules

• Gambling winnings are taxable as income. Gambling
  losses may not offset gambling wins.
• Therefore, if someone goes to the horse track and
  wins one bet and wins 500 but loses 10 more bets
  for 1,000 total, s/he is taxed on the 500 as
  income and cannot offset it with the 1,000 loss!
• If an income interest is split from a remainder
  interest (such as one person being entitled to
  trust income and the other to trust principal at
  some point later on), the income earned is taxed
  as income and the remainder is principal and not
  subject to income tax!

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Personal Injury Recoveries 1

• To be exempt from income tax under the personal
  injury exemption rule, the injury must be
• Personal (not a breach of contract or property
  matter)
• A physical injury or sickness
• Only compensatory damages are excludable, not
  punitive
• The following injuries are not taxed as income
  under this rule
• Damages on account of physical injury to ones
  spouse
• Wrongful death
• Emotional distress if it is a byproduct of a
  physical injury
• Damages for pain and suffering, medical expenses
  and lost wages

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Personal Injury Recoveries 2

• The following are not excludable (and are income)
  under this rule
• Interest earned on damages before they are paid
• Recoveries for medical expenses already
  deductible under the medical expenses rules
• Punitive Damages

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Repayment and Discharge of Loans

• A repayment of a loan is, of course, not taxable,
  but the interest on the loan is taxable.
• If a loan is discharged for less than the amount
  of indebtedness, the difference is considered
  income.
• Exceptions
• The taxpayer is bankrupt or insolvent
• The debt is a purchase money mortgage (or a
  non-recourse debt) and the property is
  repossessed - if the creditor just takes the
  value of the repossessed property, thats not
  income to the debtor
• The discharged amount would have been deductible
  if paid
• Discharge of student loans
• Where the debt is disputed

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Some Other Tax Exemptions

• Some state or municipal bonds are exempt from tax
  (although they usually pay a lower interest rate)
• Exemption for sale of personal residence (121)
• If the taxpayer sells a personal residence in
  which s/he has lived for at least 2 of the last 5
  years, the first 250,000 (500,000 for married
  couples) is exempt from capital gains tax.
• If the taxpayer was forced by certain unforeseen
  circumstances to move and thus didnt live there
  for 2 years, s/he gets a partial exemption based
  on the amount of time actually lived in the
  residence.