Optimize Your Capital Gain Treatment

Carefully document the purpose for holding your assets


Key Takeaways:

  • Long-term capital gains associated with assets held over one year are generally taxed at a maximum federal rate of 20 percent — not the top ordinary rate of 39.6 percent.

  • Just be careful if you are planning to sell collectibles, gold futures or foreign currency. The tax rate is generally higher.

  • The more you can document your purpose for holding your assets (at the time of purchase and disposition), the better your chances of a favorable tax result.

  • The deductibility of net capital losses in excess of $3,000 is generally deferred to future years.

 

There’s no shortage of confusion about the current tax landscape—both short-term and long term—but here are some steps you can take to protect yourself from paying a higher tax rate than necessary as we march into a new normal world.

Capital assets vs. ordinary income assets

The IRS oddly defines a capital asset by describing what it is not, rather than describing what it is. For instance, the following “ordinary income” assets are not considered capital assets: Inventory, property held for sale to customers, artistic compositions created by the taxpayer’s personal efforts, and accounts or notes receivable acquired or originating in the ordinary course of a trade or business. With the 2017 Tax Cuts and Jobs Act signed into law, self-created patents and other intellectual property will be added to this list.

Assets used in a trade or business that qualify for depreciation, also known as “Section 1231 Assets,” are not capital assets. However, a disposition of such property that results in a gain may enjoy, at least partially, capital gain treatment.

Most other noncash assets are considered capital assets. However, the tax consequences upon disposition are further dependent on whether these assets are held for investment or personal use.

Personal assets

Assets acquired primarily for personal use are generally not purchased with the primary intent of anticipating future appreciation. Nevertheless, if such an asset does appreciate, the gain from its sale is taxed as a capital gain. In the case of a gain on the sale of a personal residence, the capital gain is first reduced by a generous exclusion, in most cases up to $500,000 for joint filers. Losses on sales of personal assets, however, are rarely deductible.

Investment assets

In addition to creating wealth through appreciation, investment assets may also produce a current income stream in the form of interest, dividends, royalties or rents. The most common investments are:

  • Real property

  • Securities

  • Collectibles

Dealer vs. investor vs. trader

In the case of the three asset categories above, whether a holding is considered an “ordinary income asset” or a “capital asset” depends primarily on what you intend to do with those assets. Intent is most important at the time of disposition (i.e. sale), but asset re-characterization during the holding period may be more closely scrutinized in an audit.

In general, a “dealer” acts as a merchant or middleman, purchasing assets at one price and selling them to customers at a higher price to reflect compensation (“markup”) for risk, handling costs and other services. An “investor” holds property to benefit from the appreciation upon a later disposition. Difficulties arise when you, the taxpayer, act as a dealer in some transactions and as an investor in others—or if you acquire an asset with the intent to resell it, and then decide later to retain it as an investment.

Conclusion

Characterizing an asset as ordinary or capital can result in a significant tax rate differential. It can also affect your ability to net gains and losses against other taxable activities. So you must spend the time and effort needed to document the intent of the acquisition of an asset, as well as any facts that might change the character of the asset, during the holding period.

Sure, we’re all busy. But, in today’s unpredictable regulatory and tax landscape, don’t you think it’s worth taking the time to do so in order to potentially cut your future tax rate in half?’

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

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