Primer: Capital Gains Tax

A capital gains tax is a tax charged on capital gains – profits from the sale of a non-inventory asset that was purchased at a lower price. This is commonly placed on the sale of company stocks and bonds, as well as precious metals and real estate properties. US tax regulations divide this into short-term and long-term gains. Short-term refers to capital owned for one year or less, while long-term is includes capital owned for more than one year but less than five years prior to their sale.

Within the US, both individuals and corporations pay income tax on the net total of all capital gains just as they would for any other income, but with a lower rate for long-term capital gains. The tax rate on such gains was reduced to 5% from the original 15% in 2003 for those who belong to the two lowest income brackets. Short-term capital gains fall under the ordinary income tax rate.

Provisions on Section 2011 of the Small Business Jobs Act of 2010 allows for an exemption of 100% of taxes on capital gains for angel and venture capital investors in small business investments if held for a period of five years. The temporary exclusion of capital gains tax was part of the Tax Relief, Unemployment Insurance Re-authorization, and Job Creation Act of 2010 as part of an economic stimulus. The new 2011 budget is set to propose making the elimination of the capital gains tax on key investments in small businesses permanent, and has been passed as a temporary provision in the Small Business Jobs Act of 2010.

It has been noted that the capital gain which the tax is calculated on has not been adjusted for currency inflation. This result in scenarios where the gain is entirely due to inflation and is, therefore, not a gain at all. Nevertheless, the illusory gain in these circumstances is still taxed. Similarly, situations where the property’s value does not keep pace due to inflation will find themselves taxed as gains when they actually result in a loss.

In general, investing in companies and holding that investment in the long-term will result in the lowest rate of capital gains tax. However, this is highly simplistic and does not factor in potential changes, such as the value of the company and economic shifts.

The IRS allows for individuals to defer their capital gains tax with strategies such as the structured sale, charitable trust, installment sale, private annuity trust and a 1031 exchange. Note that US citizens are subject to paying US taxes on their income, regardless of where they reside, as per current tax regulations.