Capital Gains
and Losses
This section discusses the tax treatment of gains and losses from
different types of investment transactions.
Character of gain or loss. You need to classify your gains and
losses as either ordinary or capital gains or losses. You then need to classify your
capital gains and losses as either short-term or long-term. If you have long-term gains
and losses, you must identify your 28% rate gains and losses. If you have a net capital
gain, you must also identify your qualified 5-year gain and any unrecaptured section 1250
gain.
The correct classification and identification helps you figure the limit on capital
losses and the correct tax on capital gains. Reporting capital gains and losses is
explained in chapter 17.
Capital or Ordinary
Gain or Loss
If you have a taxable gain or a deductible loss from a transaction, it may be either a
capital gain or loss or an ordinary gain or loss, depending on the circumstances.
Generally, a sale or trade of a capital asset (defined next) results in a capital gain or
loss. A sale or trade of a noncapital asset generally results in ordinary gain or loss.
Depending on the circumstances, a gain or loss on a sale or trade of property used in a
trade or business may be treated as either capital or ordinary, as explained in
Publication 544. In some situations, part of your gain or loss may be a capital gain or
loss, and part may be an ordinary gain or loss.
Capital Assets and Noncapital Assets
For the most part, everything you own and use for personal purposes,
pleasure, or investment is a capital asset. Some examples are:
- Stocks or bonds held in your personal account,
- A house owned and used by you and your family,
- Household furnishings,
- A car used for pleasure or commuting,
- Coin or stamp collections,
- Gems and jewelry, and
- Gold, silver, or any other metal.
Any property you own is a capital asset, except the following noncapital assets.
- Property held mainly for sale to customers or property that will
physically become a part of the merchandise that is for sale to customers.
- Depreciable property used in your trade or business, even if fully
depreciated.
- Real property used in your trade or business.
- A copyright, a literary, musical, or artistic composition, a letter or
memorandum, or similar property:
- Created by your personal efforts,
- Prepared or produced for you as a letter, memorandum, or similar property, or
- Acquired under circumstances (for example, by gift) entitling you to the basis of the
person who created the property or for whom it was prepared or produced.
- Accounts or notes receivable acquired in the ordinary course of a trade
or business for services rendered or from the sale of property described in (1).
- U.S. Government publications that you received from the government free
or for less than the normal sales price, or that you acquired under circumstances
entitling you to the basis of someone who received the publications free or for less than
the normal sales price.
- Certain commodities derivative financial instruments held by commodities
derivatives dealers.
- Hedging transactions, but only if the transaction is clearly identified
as a hedging transaction before the close of the day on which it was acquired, originated,
or entered into.
- Supplies of a type you regularly use or consume in the ordinary course
of your trade or business.
Investment Property
Investment property is a capital asset. Any gain or loss from
its sale or trade is generally a capital gain or loss.
Gold, silver, stamps, coins, gems, etc. These are capital assets
except when they are held for sale by a dealer. Any gain or loss you have from their sale
or trade generally is a capital gain or loss.
Stocks, stock rights, and bonds. All of these (including stock
received as a dividend) are capital assets except when held for sale by a securities
dealer. However, if you own small business stock, see Losses on Section 1244 (Small
Business) Stock and Losses on Small Business Investment Company Stock in
chapter 4 of Publication 550.
Personal use property. Property held for personal use only, rather
than for investment, is a capital asset, and you must report a gain from its sale as a
capital gain. However, you cannot deduct a loss from selling personal use property.
Discounted Debt Instruments
Treat your gain or loss on the sale, redemption, or retirement of a
bond or other debt instrument originally issued at a discount or bought at a
discount as capital gain or loss, except as explained in the following discussions.
Short-term government obligations. Treat gains on short-term
federal, state, or local government obligations (other than tax-exempt obligations) as
ordinary income up to your ratable share of the acquisition discount. This treatment
applies to obligations that have a fixed maturity date not more than 1 year from the date
of issue. Acquisition discount is the stated redemption price at maturity
minus your basis in the obligation.
However, do not treat these gains as income to the extent you previously included the
discount in income. See Discount on Short-Term Obligations in chapter 1 of
Publication 550.
Short-term nongovernment obligations. Treat gains on short-term
nongovernment obligations as ordinary income up to your ratable share of original issue
discount (OID). This treatment applies to obligations that have a fixed maturity date of
not more than 1 year from the date of issue.
However, to the extent you previously included the discount in income, you do not have
to include it in income again. See Discount on Short-Term Obligations in chapter
1 of Publication 550.
Tax-exempt state and local government bonds. If these bonds were originally issued at a discount before September 4, 1982,
or you acquired them before March 2, 1984, treat your part of the OID as tax-exempt
interest. To figure your gain or loss on the sale or trade of these bonds, reduce the
amount realized by your part of the OID.
If the bonds were issued after September 3, 1982, and acquired after March 1, 1984,
increase the adjusted basis by your part of the OID to figure gain or loss. For more
information on the basis of these bonds, see Discounted Debt Instruments in
chapter 4 of Publication 550.
Any gain from market discount is usually taxable on disposition or redemption of
tax-exempt bonds. If you bought the bonds before May 1, 1993, the gain from market
discount is capital gain. If you bought the bonds after April 30, 1993, the gain is
ordinary income.
You figure the market discount by subtracting the price you paid for the bond from the
sum of the original issue price of the bond and the amount of accumulated OID from the
date of issue that represented interest to any earlier holders. For more information, see Market
Discount Bonds in chapter 1 of Publication 550.
A loss on the sale or other disposition of a tax-exempt state or local government bond
is deductible as a capital loss.
Redeemed before maturity. If a state or local bond that was
issued before June 9, 1980, is redeemed before it matures, the OID is not
taxable to you.
If a state or local bond issued after June 8, 1980, is redeemed before
it matures, the part of the OID that is earned while you hold the bond is not taxable to
you. However, you must report the unearned part of the OID as a capital gain.
Example. On July 1, 1991, the date of issue, you bought a
20-year, 6% municipal bond for $800. The face amount of the bond was $1,000. The $200
discount was OID. At the time the bond was issued, the issuer had no intention of
redeeming it before it matured. The bond was callable at its face amount beginning 10
years after the issue date.
The issuer redeemed the bond at the end of 11 years (July 1, 2002) for its face amount
of $1,000 plus accrued annual interest of $60. The OID earned during the time you held the
bond, $73, is not taxable. The $60 accrued annual interest also is not taxable. However,
you must report the unearned part of the OID ($127) as a capital gain.
Long-term debt instruments issued after 1954 and before May 28, 1969 (or before
July 2, 1982, if a government instrument). If you sell, trade, or
redeem for a gain one of these debt instruments, the part of your gain that is not more
than your ratable share of the OID at the time of the sale or redemption is ordinary
income. The rest of the gain is capital gain. If, however, there was an intention to call
the debt instrument before maturity, all of your gain that is not more than the entire OID
is treated as ordinary income at the time of the sale. This treatment of taxable gain also
applies to corporate instruments issued after May 27, 1969, under a written commitment
that was binding on May 27, 1969, and at all times thereafter.
Long-term debt instruments issued after May 27, 1969 (or after July 1, 1982, if
a government instrument). If you hold one of these debt instruments,
you must include a part of the OID in your gross income each year that you own the
instrument. Your basis in that debt instrument is increased by the amount of OID that you
have included in your gross income. See Original Issue Discount (OID) in chapter
8 for information about the OID that you must report on your tax return.
If you sell or trade the debt instrument before maturity, your gain is a capital gain.
However, if at the time the instrument was originally issued there was an intention to
call it before its maturity, your gain generally is ordinary income to the extent of the
entire OID reduced by any amounts of OID previously includible in your income. In this
case, the rest of the gain is a capital gain.
Market discount bonds. If the debt instrument has market
discount and you chose to include the discount in income as it accrued, increase your
basis in the debt instrument by the accrued discount to figure capital gain or loss on its
disposition. If you did not choose to include the discount in income as it accrued, you
must report gain as ordinary interest income up to the instrument's accrued market
discount. The rest of the gain is capital gain. See Market Discount Bonds in
chapter 1 of Publication 550.
A different rule applies to market discount bonds issued before July 19, 1984, and
purchased by you before May 1, 1993. See chapter 4 of Publication 550.
Retirement of debt instrument. Any amount that you receive
on the retirement of a debt instrument is treated in the same way as if you had sold or
traded that instrument.
Notes of individuals. If you hold an obligation of an individual
that was issued with OID after March 1, 1984, you generally must include the OID in your
income currently, and your gain or loss on its sale or retirement is generally capital
gain or loss. An exception to this treatment applies if the obligation is a loan between
individuals and all of the following requirements are met.
- The lender is not in the business of lending money.
- The amount of the loan, plus the amount of any outstanding prior loans, is $10,000 or
less.
- Avoiding federal tax is not one of the principal purposes of the loan.
If the exception applies, or the obligation was issued before March 2, 1984, you do not
include the OID in your income currently. When you sell or redeem the obligation, the part
of your gain that is not more than your accrued share of the OID at that time is ordinary
income. The rest of the gain, if any, is capital gain. Any loss on the sale or redemption
is capital loss.
Deposit in Insolvent or Bankrupt Financial Institution
If you lose money you have on deposit in a qualified financial
institution that becomes insolvent or bankrupt, you may be able to deduct your loss
in one of three ways.
- Ordinary loss,
- Casualty loss, or
- Nonbusiness bad debt (short-term capital loss).
Ordinary loss or casualty loss. If you can reasonably
estimate your loss, you can choose to treat the estimated loss as either an ordinary loss
or a casualty loss in the current year. Either way, you claim the loss as an itemized
deduction.
If you claim an ordinary loss, report it as a miscellaneous itemized deduction on line
22 of Schedule A (Form 1040). The maximum amount you can claim is $20,000 ($10,000 if you
are married filing separately) reduced by any expected state insurance proceeds. Your loss
is subject to the 2%-of-adjusted-gross-income limit. You cannot choose to claim an
ordinary loss if any part of the deposit is federally insured.
If you claim a casualty loss, attach Form 4684, Casualties and Thefts, to
your return. Each loss must be reduced by $100. Your total casualty losses for the year
are reduced by 10% of your adjusted gross income.
You cannot choose either of these methods if:
- You own at least 1% of the financial institution,
- You are an officer of the institution, or
- You are related to such an owner or officer. You are related if you and the owner or
officer are related parties, as defined earlier under Related Party
Transactions, or if you are the aunt, uncle, nephew, or niece of the owner or
officer.
If the actual loss that is finally determined is more than the amount you deducted as
an estimated loss, you can claim the excess loss as a bad debt. If the actual loss is less
than the amount deducted as an estimated loss, you must include in income (in the final
determination year) the excess loss claimed. See Recoveries in Publication 525, Taxable
and Nontaxable Income.
Nonbusiness bad debt. If you choose to treat the loss as a
bad debt, see How to report bad debts, later.
Sale of Annuity
The part of any gain on the sale of an annuity contract before its maturity date that
is based on interest accumulated on the contract is ordinary income.
Nonbusiness Bad Debts
If someone owes you money that you cannot collect, you have a bad
debt. You may be able to deduct the amount owed to you when you figure your tax for
the year the debt becomes worthless. A debt must be genuine for you to deduct a loss. A
debt is genuine if it arises from a debtor-creditor relationship based on a valid and
enforceable obligation to repay a fixed or determinable sum of money.
Bad debts that you did not get in the course of operating your trade or business are
nonbusiness bad debts. To be deductible, nonbusiness bad debts must be totally worthless.
You cannot deduct a partly worthless nonbusiness debt.
Basis in bad debt required. To
deduct a bad debt, you must have a basis in it - that is, you must have already included
the amount in your income or loaned out your cash. For example, you cannot claim a
bad debt deduction for court-ordered child support not paid to you by your former spouse.
If you are a cash method taxpayer (as most individuals are), you generally cannot take a
bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and
similar items.
How to report bad debts. Deduct nonbusiness bad debts as short-term
capital losses on Schedule D (Form 1040).
In Part I, line 1 of Schedule D, enter the name of the debtor and statement
attached in column (a). Enter the amount of the bad debt in parentheses in column
(f). Use a separate line for each bad debt.
For each bad debt, attach a statement to your return that contains:
- A description of the debt, including the amount, and the date it became due,
- The name of the debtor, and any business or family relationship between you and the
debtor,
- The efforts you made to collect the debt, and
- Why you decided the debt was worthless. For example, you could show that the borrower
has declared bankruptcy, or that legal action to collect would probably not result in
payment of any part of the debt.
Filing a claim for refund. If you do not deduct a bad debt on your original return for the year it
becomes worthless, you can file a claim for a credit or refund due to the bad debt.
To do this, use Form 1040X, Amended U.S. Individual Income Tax Return, to amend
your return for the year the debt became worthless. You must file it within 7 years from
the date your original return for that year had to be filed, or 2 years from the date you
paid the tax, whichever is later. For more information about filing a claim, see Amended
Returns and Claims for Refund in chapter 1.
Additional information. For more information, see Nonbusiness
Bad Debts in Publication 550. For information on business bad debts, see chapter 11
of Publication 535, Business Expenses.
Losses on Small Business Stock
You can deduct as an ordinary loss, rather than as a capital loss,
your loss on the sale, trade, or worthlessness of section 1244 stock. Report the
loss on Form 4797, line 10. Any gain on this stock is capital gain and is reported
on Schedule D (Form 1040) if the stock is a capital asset in your hands. See Losses on
Section 1244 (Small Business) Stock in chapter 4 of Publication 550.
Losses on Small Business Investment Company Stock
See Losses on Small Business Investment Company Stock in chapter 4 of
Publication 550.
Holding Period
If you sold or traded investment property, you must determine your
holding period for the property. Your holding period determines whether any capital
gain or loss was a short-term or long-term capital gain or loss.
Long term or short term. If you hold investment property more
than 1 year, any capital gain or loss is a long-term capital gain
or loss. If you hold the property 1 year or less, any capital gain or loss
is a short-term capital gain or loss.
To determine how long you held the investment property, begin counting on the date
after the day you acquired the property. The day you disposed of the property is part of
your holding period.
Example. If you bought investment property on February 5, 2001,
and sold it on February 5, 2002, your holding period is not more than 1 year and you have
a short-term capital gain or loss. If you sold it on February 6, 2002, your holding period
is more than 1 year and you will have a long-term capital gain or loss.
Securities traded on established market. For securities traded on an
established securities market, your holding period begins the day after the trade date you
bought the securities, and ends on the trade date you sold them.
 Do not confuse
the trade date with the settlement date, which is the date by which the stock must be
delivered and payment must be made.
Example. You are a cash method, calendar year taxpayer. You sold
stock at a gain on December 27, 2002. According to the rules of the stock exchange, the
sale was closed by delivery of the stock three trading days after the sale, on January 2,
2003. You received payment of the sales price on that same day. Report your gain on your
2002 return, even though you received the payment in 2003. The gain is long term or short
term depending on whether you held the stock more than 1 year. Your holding period ended
on December 27. If you had sold the stock at a loss, you would also report it on your 2002
return.
Nontaxable trades. If you
acquire investment property in a trade for other investment property and your basis for
the new property is determined, in whole or in part, by your basis in the old
property, your holding period for the new property begins on the day following the date
you acquired the old property.
Property received as a gift. If
you receive a gift of property and your basis is determined by the donor's adjusted basis,
your holding period is considered to have started on the same day the donor's
holding period started.
If your basis is determined by the fair market value of the property, your holding
period starts on the day after the date of the gift.
Inherited property. If you
inherit investment property, your capital gain or loss on any later disposition of that
property is treated as a long-term capital gain or loss. This is true regardless of
how long you actually held the property.
Real property bought. To figure how long you have held real property
bought under an unconditional contract, begin counting on the day after you received title
to it or on the day after you took possession of it and assumed the burdens and privileges
of ownership, whichever happened first. However, taking delivery or possession of real
property under an option agreement is not enough to start the holding period. The holding
period cannot start until there is an actual contract of sale. The holding period of the
seller cannot end before that time.
Automatic investment service. In
determining your holding period for shares bought by the bank or other agent, full shares
are considered bought first and any fractional shares are considered bought last.
Your holding period starts on the day after the bank's purchase date. If a share was
bought over more than one purchase date, your holding period for that share is a split
holding period. A part of the share is considered to have been bought on each date that
stock was bought by the bank with the proceeds of available funds.
Stock dividends. The holding
period for stock you received as a taxable stock dividend begins on the date of
distribution.
The holding period for new stock you received as a nontaxable stock dividend begins on
the same day as the holding period of the old stock. This rule also applies to stock
acquired in a spin-off, which is a distribution of stock or securities in a
controlled corporation.
Nontaxable stock rights. Your
holding period for nontaxable stock rights begins on the same day as the holding period of
the underlying stock. The holding period for stock acquired through the exercise of
stock rights begins on the date the right was exercised.
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