Publication 550
Investment Income and Expenses

(Including Capital Gains and Losses)

For use in preparing 2002 Returns

Rollover of Gain
From Sale of
Empowerment Zone Assets

You may qualify for a tax-free rollover of certain gains from the sale of qualified empowerment zone assets. This means that if you buy certain replacement property and make the choice described in this section, you postpone part or all of the recognition of your gain.

You qualify to make this choice if you meet all the following tests.

1. You hold a qualified empowerment zone asset for more than 1 year and sell it at a gain.
2. Your gain from the sale is a capital gain.
3. During the 60-day period beginning on the date of the sale, you buy a replacement qualified empowerment zone asset in the same zone as the asset sold.

Any part of the gain that is ordinary income cannot be postponed and must be recognized.

Qualified empowerment zone asset.   This means certain stock or partnership interests in an enterprise zone business. It also includes certain tangible property used in an enterprise zone business. You must have acquired the asset after December 21, 2000.

Amount of gain recognized.   If you make the choice described in this section, you must recognize gain only up to the following amount:

1. The amount realized on the sale, minus
2. The cost of any qualified empowerment zone asset that you bought during the 60-day period beginning on the date of sale (and did not previously take into account in rolling over gain on an earlier sale of qualified empowerment zone assets).

If this amount is equal to or more than the amount of your gain, you must recognize the full amount of your gain. If this amount is less than the amount of your gain, you can postpone the rest of your gain by adjusting the basis of your replacement property as described next.

Basis of replacement property.   You must subtract the amount of postponed gain from the basis of the qualified empowerment zone assets you bought as replacement property.

How to report and postpone capital gain.    Report the entire gain realized from the sale on line 8 of Schedule D (Form 1040). To make the choice to postpone gain, enter Section 1397B Rollover in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

More information.    For more information about empowerment zones, see Publication 954, Tax Incentives for Empowerment Zones and Other Distressed Communities. For more information about this rollover of gain, see section 1397B of the Internal Revenue Code.

Reporting Capital
Gains and Losses

This section discusses how to report your capital gains and losses on Schedule D (Form 1040). Enter your sales and trades of stocks, bonds, etc., and real estate (if not required to be reported on another form) on line 1 of Part I or line 8 of Part II, as appropriate. Include all these transactions even if you did not receive a Form 1099-B or 1099-S (or substitute statement). You can use Schedule D-1 as a continuation schedule to report more transactions.

Be sure to add all sales price entries in column (d) of lines 1 and 2 and enter the total on line 3. Also add all sales price entries in column (d) of lines 8 and 9 and enter the total on line 10. Then add the following amounts reported to you for 2002 on Forms 1099-B and Forms 1099-S (or on substitute statements):

1. Proceeds from transactions involving stocks, bonds, and other securities, and
2. Gross proceeds from real estate transactions (other than the sale of your main home if you had no taxable gain) not reported on another form or schedule.

If this total is more than the total of lines 3 and 10, attach a statement to your return explaining the difference.

Installment sales.   You cannot use the installment method to report a gain from the sale of stock or securities traded on an established securities market. You must report the entire gain in the year of sale (the year in which the trade date occurs).

At-risk rules.   Special at-risk rules apply to most income-producing activities. These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. The at-risk rules also apply to a loss from the sale or trade of an asset used in an activity to which the at-risk rules apply. For more information, see Publication 925, Passive Activity and At-Risk Rules. Use Form 6198, At-Risk Limitations, to figure the amount of loss you can deduct.

Passive activity gains and losses.   If you have gains or losses from a passive activity, you may also have to report them on Form 8582. In some cases, the loss may be limited under the passive activity rules. Refer to Form 8582 and its separate instructions for more information about reporting capital gains and losses from a passive activity.

Form 1099-B transactions.   If you sold property, such as stocks, bonds, or certain commodities, through a broker, you should receive Form 1099-B or an equivalent statement from the broker. Use the Form 1099-B or equivalent statement to complete Schedule D.

Report the gross proceeds shown in box 2 of Form 1099-B as the gross sales price in column (d) of either line 1 or line 8 of Schedule D, whichever applies. However, if the broker advises you, in box 2 of Form 1099-B, that gross proceeds (gross sales price) less commissions and option premiums were reported to the IRS, enter that net sales price in column (d) of either line 1 or line 8 of Schedule D, whichever applies.

If the net amount is entered in column (d), do not include the commissions and option premiums in column (e).

Section 1256 contracts and straddles.   Use Form 6781 to report gains and losses from section 1256 contracts and straddles before entering these amounts on Schedule D. Include a copy of Form 6781 with your income tax return.

Market discount bonds.   Report the sale or trade of a market discount bond on Schedule D (Form 1040), line 1 or line 8. If the sale or trade results in a gain and you did not choose to include market discount in income currently, enter Accrued Market Discount on the next line in column (a) and the amount of the accrued market discount as a loss in column (f). Also report the amount of accrued market discount as interest income on Schedule B (Form 1040), line 1, and identify it as Accrued Market Discount.

Form 1099-S transactions.   If you sold or traded reportable real estate, you generally should receive from the real estate reporting person a Form 1099-S, Proceeds From Real Estate Transactions, showing the gross proceeds.

Reportable real estate is defined as any present or future ownership interest in any of the following:

1. Improved or unimproved land, including air space,
2. Inherently permanent structures, including any residential, commercial, or industrial building,
3. A condominium unit and its accessory fixtures and common elements, including land, and
4. Stock in a cooperative housing corporation (as defined in section 216 of the Internal Revenue Code).

A real estate reporting person could include the buyer's attorney, your attorney, the title or escrow company, a mortgage lender, your broker, the buyer's broker, or the person acquiring the biggest interest in the property.

Your Form 1099-S will show the gross proceeds from the sale or exchange in box 2. Follow the instructions for Schedule D to report these transactions, and include them on line 1 or 8 as appropriate.

It is unlawful for any real estate reporting person to separately charge you for complying with the requirement to file Form 1099-S.

Sale of property bought at various times.   If you sell a block of stock or other property that you bought at various times, report the short-term gain or loss from the sale on one line in Part I of Schedule D and the long-term gain or loss on one line in Part II. Write Various in column (b) for the Date acquired. See the Comprehensive Example later in this chapter.

Sale expenses.   Add to your cost or other basis any expense of sale such as broker's fees, commissions, state and local transfer taxes, and option premiums. Enter this adjusted amount in column (e) of either Part I or Part II of Schedule D, whichever applies, unless you reported the net sales price amount in column (d).

Short-term gains and losses.   Capital gain or loss on the sale or trade of investment property held 1 year or less is a short-term capital gain or loss. You report it in Part I of Schedule D. If the amount you report in column (f) is a loss, show it in parentheses.

You combine your share of short-term capital gain or loss from partnerships, S corporations, and fiduciaries, and any short-term capital loss carryover, with your other short-term capital gains and losses to figure your net short-term capital gain or loss on line 7 of Schedule D.

Long-term gains and losses.   A capital gain or loss on the sale or trade of investment property held more than 1 year is a long-term capital gain or loss. You report it in Part II of Schedule D. If the amount you report in column (f) is a loss, show it in parentheses.

You also report the following in Part II of Schedule D:

1. Undistributed long-term capital gains from a regulated investment company (mutual fund) or real estate investment trust (REIT),
2. Your share of long-term capital gains or losses from partnerships, S corporations, and fiduciaries,
3. All capital gain distributions from mutual funds and REITs not reported directly on line 10 of Form 1040A or line 13 of Form 1040, and
4. Long-term capital loss carryovers.

The result after combining these items with your other long-term capital gains and losses is your net long-term capital gain or loss (line 16 of Schedule D).

28% rate gain or loss.   Enter in column (g) the amount, if any, from column (f) that is a 28% rate gain or loss. Enter any loss in parentheses.

A 28% rate gain or loss is:

• Any collectibles gain or loss, or
• The part of your gain on qualified small business stock that is equal to the section 1202 exclusion.

For more information, see Capital Gain Tax Rates, later.

Capital gain distributions only.   You do not have to file Schedule D if all of the following are true.

1. The only amounts you would have to report on Schedule D are capital gain distributions from box 2a of Form 1099-DIV (or substitute statement).
2. You do not have an amount in box 2b, 2c, 2d, or 2e of any Form 1099-DIV (or substitute statement).
3. You do not file Form 4952 or, if you do, the amount on line 4e of that form is not more than zero.

If all the above statements are true, report your capital gain distributions directly on line 13 of Form 1040 and check the box on that line. Also, use the Capital Gain Tax Worksheet in the Form 1040 instructions to figure your tax.

You can report your capital gain distributions on line 10 of Form 1040A, instead of on Form 1040, if both of the following are true.

1. None of the Forms 1099-DIV (or substitute statements) you received have an amount in box 2b, 2c, 2d, or 2e.
2. You do not have to file Form 1040 for any other reason. (For example, you must not have any other capital gains or any capital losses.)

Total net gain or loss.   To figure your total net gain or loss, combine your net short-term capital gain or loss (line 7) with your net long-term capital gain or loss (line 16). Enter the result on line 17, Part III of Schedule D. If your losses are more than your gains, see Capital Losses, next. If both lines 16 and 17 are gains and line 39 of Form 1040 is more than zero, see Capital Gain Tax Rates, later.

Capital Losses

If your capital losses are more than your capital gains, you can claim a capital loss deduction. Report the deduction on line 13 of Form 1040, enclosed in parentheses.

Limit on deduction.   Your allowable capital loss deduction, figured on Schedule D, is the lesser of:

1. $3,000 ($1,500 if you are married and file a separate return), or
2. Your total net loss as shown on line 17 of Schedule D.

You can use your total net loss to reduce your income dollar for dollar, up to the $3,000 limit.

Capital loss carryover.   If you have a total net loss on line 17 of Schedule D that is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you had incurred it in that next year. If part of the loss is still unused, you can carry it over to later years until it is completely used up.

When you figure the amount of any capital loss carryover to the next year, you must take the current year's allowable deduction into account, whether or not you claimed it.

When you carry over a loss, it remains long term or short term. A long-term capital loss you carry over to the next tax year will reduce that year's long-term capital gains before it reduces that year's short-term capital gains.

Figuring your carryover.   The amount of your capital loss carryover is the amount of your total net loss that is more than the lesser of:

1. Your allowable capital loss deduction for the year, or
2. Your taxable income increased by your allowable capital loss deduction for the year and your deduction for personal exemptions.

If your deductions are more than your gross income for the tax year, use your negative taxable income in computing the amount in item (2).

Complete the Capital Loss Carryover Worksheet in the Schedule D (Form 1040) instructions to determine the part of your capital loss for 2002 that you can carry over to 2003.

Example.   Bob and Gloria sold securities in 2002. The sales resulted in a capital loss of $7,000. They had no other capital transactions. Their taxable income was $26,000. On their joint 2002 return, they can deduct $3,000. The unused part of the loss, $4,000 ($7,000 - $3,000), can be carried over to 2003.

If their capital loss had been $2,000, their capital loss deduction would have been $2,000. They would have no carryover.

Use short-term losses first.   When you figure your capital loss carryover, use your short-term capital losses first, even if you incurred them after a long-term capital loss. If you have not reached the limit on the capital loss deduction after using the short-term capital loss, use the long-term capital losses until you reach the limit.

Decedent's capital loss.   A capital loss sustained by a decedent during his or her last tax year (or carried over to that year from an earlier year) can be deducted only on the final return filed for the decedent. The capital loss limits discussed earlier still apply in this situation. The decedent's estate cannot deduct any of the loss or carry it over to following years.

Joint and separate returns.   If you and your spouse once filed separate returns and are now filing a joint return, combine your separate capital loss carryovers. However, if you and your spouse once filed a joint return and are now filing separate returns, any capital loss carryover from the joint return can be deducted only on the return of the spouse who actually had the loss.

Capital Gain Tax Rates

The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. These lower rates are called the maximum capital gain rates.

The term net capital gain means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss.

The maximum capital gain rate can be 8%, 10%, 20%, 25%, or 28%. See Table 4-2 for details.

The maximum capital gain rate does not apply if it is higher than your regular tax rate.

Example.    You have a net capital gain from selling collectibles, so the capital gain rate would be 28%. Because you are single and your taxable income is $25,000, none of your taxable income will be taxed above the 15% rate. The 28% rate does not apply.

8% rate.   The 10% maximum capital gain rate is lowered to 8% for qualified 5-year gain.

Qualified 5-year gain.   This is long-term capital gain from the sale of property that you held for more than 5 years.

18% rate beginning in 2006.   Beginning in 2006, the 20% maximum capital gain rate will be lowered to 18% for qualified 5-year gain from property with a holding period that begins after 2000.

Investment interest deducted.   If you claim a deduction for investment interest, you may have to reduce the amount of your net capital gain that is eligible for the capital gain tax rates. Reduce it by the amount of the net capital gain you choose to include in investment income when figuring the limit on your investment interest deduction. This is done on lines 21-23 of Schedule D. For more information about the limit on investment interest, see Interest Expenses in chapter 3.

Using the Capital Gain Rates

The part of a net capital gain that is subject to each rate is determined under the following rules.

1. In each of the following groups, long-term capital gains are netted with long-term capital losses.
   1. A 28% group, consisting of collectibles gains and losses, gain on qualified small business stock equal to the section 1202 exclusion, and long-term capital loss carryovers.
   2. A 25% group, consisting of unrecaptured section 1250 gain.
   3. A 20% group, consisting of gains and losses that are not in the 28% or 25% group. (This includes gains that may be taxed at a rate of 10% or 8%.)
2. A net short-term capital loss reduces any net gain from the 28% group, then any gain from the 25% group, and finally any net gain from the 20% group.
3. A net loss from the 28% group reduces any gain from the 25% group, and then any net gain from the 20% group.
4. A net loss from the 20% group reduces any net gain from the 28% group, and then any gain from the 25% group.

Collectibles gain or loss.   This is gain or loss from the sale or trade of a work of art, rug, antique, metal (such as gold, silver, and platinum bullion), gem, stamp, coin, or alcoholic beverage held more than 1 year.

Collectibles gain includes gain from the sale of an interest in a partnership, S corporation, or trust attributable to unrealized appreciation of collectibles.

Gain on qualified small business stock.   If you realized a gain from qualified small business stock that you held more than 5 years, you generally can exclude one-half of your gain from your income. The taxable part of your gain equal to your section 1202 exclusion is a 28% rate gain. See Gains on Qualified Small Business Stock, earlier in this chapter.

Unrecaptured section 1250 gain.   Generally, this is any part of your capital gain from selling section 1250 property (real property) that is due to depreciation (but not more than your net section 1231 gain), reduced by any net loss in the 28% group. Use the worksheet in the Schedule D instructions to figure your unrecaptured section 1250 gain. For more information about section 1250 property and section 1231 gain, see chapter 3 of Publication 544.

Using Schedule D.   You apply these rules by using Part IV of Schedule D (Form 1040) to figure your tax.

Use Part IV if both of the following are true.

1. You have a net capital gain. You have a net capital gain if both lines 16 and 17 of Schedule D are gains. (Line 16 is your net long-term capital gain or loss. Line 17 is your net long-term capital gain or loss combined with any net short-term capital gain or loss.)
2. Your taxable income on Form 1040, line 41, is more than zero.

If you have any collectible gain, gain on qualified small business stock, or unrecaptured section 1250 gain, you may also have to use the Schedule D Tax Worksheet in the Schedule D instructions to figure your tax. See the directions below line 19 of Schedule D.

See the Comprehensive Example, later, for an example of how to figure your tax on Schedule D using the capital gain rates.

Using Capital Gain Tax Worksheet.   If you have capital gain distributions but do not have to file Schedule D (Form 1040), figure your tax using the Capital Gain Tax Worksheet in the instructions for Form 1040A or Form 1040, whichever you file. For more information, see Capital gain distributions only, earlier.

Alternative minimum tax.   These capital gain rates are also used in figuring alternative minimum tax.

Comprehensive Example

Emily Jones is single and, in addition to wages from her job, she has income from stocks and other securities. For the 2002 tax year, she had the following capital gains and losses, which she reports on Schedule D. Her filled-in Schedule D is shown at the end of this example.

Capital gains and losses - Schedule D.   Emily sold stock in two different companies that she held for less than a year. In June, she sold 100 shares of Trucking Co. stock that she had bought in February. She had an adjusted basis of $1,150 in the stock and sold it for $400, for a loss of $750. In July, she sold 25 shares of Computer Co. stock that she bought in June. She had an adjusted basis in the stock of $2,000 and sold it for $2,500, for a gain of $500. She reports these short-term transactions on line 1 in Part I of Schedule D.

Emily had three other stock sales that she reports as long-term transactions on line 8 in Part II of Schedule D. In February, she sold 60 shares of Car Co. for $2,100. She had inherited the Car stock from her father. Its fair market value at the time of his death was $2,500, which became her basis. Her loss on the sale is $400. Because she had inherited the stock, her loss is a long-term loss, regardless of how long she and her father actually held the stock. She enters the loss in column (f) of line 8.

In June, she sold 500 shares of Furniture Co. stock for $5,000. She had bought 100 of those shares in 1991, for $1,000. She had bought 100 more shares in 1993 for $2,200, and an additional 300 shares in 1996 for $1,500. Her total basis in the stock is $4,700. She has a $300 ($5,000 - $4,700) gain on this sale, which she enters in column (f) of line 8. Because she held all 500 shares for more than 5 years, the entire gain is qualified 5-year gain.

In December, she sold 20 shares of Toy Co. stock for $4,100. This was qualified small business stock that she had bought in September 1997. Her basis is $1,100, so she has a $3,000 gain, which she enters in column (f) of line 8. Because she held the stock more than 5 years, she has a $1,500 section 1202 exclusion. She enters that amount in column (g) as a 28% rate gain and claims the exclusion on the line below by entering $1,500 as a loss in column (f).

She received a Form 1099-B (not shown) from her broker for each of these transactions. The entries shown in box 2 of these forms total $14,100.

Reconciliation of Forms 1099-B.   Emily makes sure that the total of the amounts reported in column (d) of lines 3 and 10 of Schedule D is not less than the total of the amounts shown on the Forms 1099-B she received from her broker. For 2002, the total of lines 3 and 10 of Schedule D is $14,100, which is the same amount reported by the broker on Forms 1099-B.

Form 6781.   During 2002, Emily had a realized loss from a regulated futures contract of $11,000. She also had an unrealized marked to market gain on open contracts of $27,000 at the end of 2002. She had reported an unrealized marked to market gain of $1,000 on her 2001 tax return. (This $1,000 must be subtracted from her 2002 profit.) These amounts are shown in boxes 6, 7, and 8 of the Form 1099-B she received from her broker. Box 9 shows her combined profit of $15,000 ($27,000 - $1,000 - $11,000). She reports this gain in Part I of Form 6781 (not shown). She shows 40% as short-term gain on line 4 of Schedule D and 60% as long-term gain on line 11 of Schedule D.

The Form 1099-B that Emily received from her broker, XYZ Trading Co., is shown later.

Capital loss carryover from 2001.   Emily has a capital loss carryover to 2002 of $800, of which $300 is short-term capital loss, and $500 is long-term capital loss. She enters these amounts on lines 6 and 14 of Schedule D.

She kept the completed Capital Loss Carryover Worksheet in her 2001 Schedule D instructions (not shown), so she could properly report her loss carryover for the 2002 tax year without refiguring it.

Tax computation.   Because Emily has gains on both lines 16 and 17 of Schedule D and has taxable income, she goes to Part IV of Schedule D to figure her tax. But because line 15 of Schedule D is more than zero (due to her section 1202 gain from selling qualified small business stock), she must also use the Schedule D Tax Worksheet to figure her tax. She must also complete the Qualified 5-Year Gain Worksheet (not shown) in her Schedule D instructions.

After entering the gain from line 17 on line 13 of her Form 1040, she completes the rest of Form 1040 through line 41. She enters the amount from that line, $30,000, on line 1 of the Schedule D Tax Worksheet. After filling out the rest of that worksheet, she figures her tax is $3,958. This is less than the tax she would have figured without the capital gain tax rates, $4,453.

Schedule D (Form 1040)

Schedule D, page 2

Schedule D worksheet

Form 1099-B

Special Rules for
Traders in Securities

Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions.

• You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
• Your activity must be substantial.
• You must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in determining if your activity is a securities trading business.

• Typical holding periods for securities bought and sold.
• The frequency and dollar amount of your trades during the year.
• The extent to which you pursue the activity to produce income for a livelihood.
• The amount of time you devote to the activity.

If your trading activities are not a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a day trader.

Note.   You may be a trader in some securities and have other securities you hold for investment. The special rules discussed here do not apply to the securities held for investment. You must keep detailed records to distinguish the securities. The securities held for investment must be identified as such in your records on the day you got them (for example, by holding them in a separate brokerage account).

How To Report

Transactions from trading activities result in capital gains and losses and must be reported on Schedule D (Form 1040). Losses from these transactions are subject to the limit on capital losses explained earlier in this chapter.

Mark-to-market election made.   If you made the mark-to-market election, you should report all gains and losses from trading as ordinary gains and losses in Part II of Form 4797, instead of as capital gains and losses on Schedule D. In that case, securities held at the end of the year in your business as a trader are marked to market by treating them as if they were sold (and reacquired) for fair market value on the last business day of the year. But do not mark to market any securities you held for investment. Report sales from those securities on Schedule D, not Form 4797.

Expenses.   Interest expense and other investment expenses that an investor would deduct on Schedule A (Form 1040) are deducted by a trader on Schedule C (Form 1040), Profit or Loss From Business, if the expenses are from the trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss. The limit on investment interest expense, which applies to investors, does not apply to interest paid or incurred in a trading business.

Self-employment tax.   Gains and losses from selling securities as part of a trading business are not subject to self-employment tax. This is true whether the election is made or not.

How To Make the
Mark-to-Market Election

To make the mark-to-market election for 2003, you must file a statement by April 15, 2003. This statement should be attached to either your 2002 individual income tax return or a request for an extension of time to file that return. The statement must include the following information.

1. That you are making an election under section 475(f) of the Internal Revenue Code.
2. The first tax year for which the election is effective.
3. The trade or business for which you are making the election.

If you are not required to file a 2002 income tax return, you make the election by placing the above statement in your books and records no later than March 17, 2003. Attach a copy of the statement to your 2003 return.

After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 99-49. Revenue Procedure 99-49 requires you to file Form 3115, Application for Change in Accounting Method. Follow its instructions. Label the Form 3115 as filed under Section 10A of the APPENDIX of Rev. Proc. 99-49.

Once you make the election, it will apply to 2003 and all later tax years, unless you get permission from IRS to revoke it. The effect of making the election is described under Mark-to-market election made, earlier.

For more information on this election, see Revenue Procedure 99-17, 1999-1 CB 503.

- Continue -