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What Is the
Capital Gains Tax?
Capital gains are the
profits realized from the sale of
capital assets, such as stocks, bonds,
and property. The capital gains tax is
triggered only when an asset is sold,
not while the asset is held by an
investor. However, mutual fund investors
could be charged capital gains on
investments in the fund that are sold by
the fund during the year.
There are two types of
capital gains: long term and short term;
each has different tax rates.
Long-term gains are profits on
assets held longer than 12 months before
they are sold. As a result of the 2003
tax law, the long-term capital gains tax
was reduced from 20% to 15% (5% for
individuals in the 10% and 15% tax
brackets) through 2010; it will revert
back to the original 20% rate in 2011
unless Congress acts to extend the tax
law. From 2008 to 2011, no tax will be
levied on long-term gains for those in
the two lowest tax brackets.
Short-term gains (on assets
held for 12 months or less), on the
other hand, are taxed as ordinary income
at the seller’s marginal income tax
rate.
The taxable amount of
each gain is determined by a “cost
basis”— in other words, the original
purchase price adjusted for additional
improvements or investments, taxes paid
on dividends, certain fees, and any
depreciation of the assets. In addition,
any capital losses incurred in the
current tax year or previous years can
be used to offset taxes on current-year
capital gains. Losses of up to $3,000 a
year may be claimed as a tax deduction.
If you have been
purchasing shares in a mutual fund over
several years and want to sell some
holdings, instruct your financial
professional to sell shares that you
purchased for the highest amount of
money, because this will reduce your
capital gains. Also, be sure to specify
which shares you are selling so that you
can take advantage of the lower rate on
long-term gains. The IRS may assume that
you are selling shares you have held for
a shorter time and tax you using
short-term rates.
Capital gains
distributions for the prior year are
reported to you by January 31, and any
taxes that must be paid on gains are due
on the date of your tax return. The
reduced rates on long-term capital gains
taxes may not be around much longer if
Congress doesn’t extend the 20% reduced
rate beyond 2010, so it may be wise to
take advantage of the lower rates before
they are scheduled to expire.
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