Tag: capital gains

Capital Gains and Losses: How Do They Work?

Selling a capital asset results in a gain or loss and impacts your income taxes.

How do capital gains and losses work?A capital gain is a profit made when you as an individual or business sell a capital asset — investments or real estate, for instance — for a higher cost than its purchase price. A capital loss is incurred when there’s a decrease in the capital asset value compared with its purchase price. Almost everything you own and use for personal or investment purposes is a capital asset: a home, personal-use items like furnishings, and collectibles.

A capital gain may be short term (one year or less) or long term (more than a year). The capital gain must be claimed on income taxes. While capital gains are generally associated with stocks and mutual funds due to their volatility, a capital gain can occur on any security sold for a higher price than the price that was paid for it. Unrealized gains and losses, sometimes referred to as paper gains and losses, reflect an increase or decrease in an investment’s value but haven’t yet triggered a taxable event.

The profit you realize when you sell a capital asset at a profit is your gain over basis paid. Basis is often defined as the original price plus any related transaction costs; basis also may refer to capital improvements and cost of sale. Capital losses are used to offset capital gains of the same type: short-term losses are deducted against short-term gains, for example.

Capital gains and losses for businesses

A business may gain or lose money in two ways: It can make a profit on its sales activities or lose money by spending more than it brings in from sales. And, of course, it can gain or lose money based on its investments or sales of assets — items of value that the business owns.

Each type is taxed differently. Profits are taxed as ordinary income and at regular business or personal tax rates. Gains or losses on investments or the sale of assets are taxed as capital gains or losses, but it can depend on the type of business. When expensive equipment is involved, businesses have to consider depreciation, which takes into account the equipment’s declining value over its useful lifetime.

Capital gains and losses can come into play when a business writes off an asset, taking it off its balance sheet. That might be the case with accounts receivable when a debt is owed to the business but is unlikely ever to be paid.

Individual shareholders or business owners who sell their capital shares or owner’s equity in a business also incur capital gains or losses from those sales. Note the following distinction: Operating profits and losses result from the ongoing operations of the business; sometimes called net operating losses for tax purposes, they result from day-to-day operations.

We’ve got your back

Whether you’re buying or selling as an individual or as a business, be sure to keep track of your sales and discuss them with a qualified financial professional. The experts at KRS can help you determine whether you have a gain on loss and its tax implications. Contact managing partner Maria Rollins at [email protected] or 201.655.7411 for a complimentary initial consultation.

How to Defer Taxes on Capital Gains

Here’s how receiving installment payments can help you defer taxes on capital gains.

What Is an Installment Sale?

An installment sale is an agreement under which at least one payment is received after the end of the tax year in which the sale occurs. When a real estate investor sells a property on the installment basis, a down payment is usually received at closing with the balance of the purchase price paid in installments in subsequent years. As the seller, you are not required to report an installment sale using this method. However, installment sale reporting allows you to spread the tax liability over all the years in which the buyer makes installment payments.

installment sales tax benefits in real estateUnder the installment method, each year the portion of the gain received via installment payments is included in the seller’s income. Fundamentally, interest should be charged on an installment sale. If the interest charged is less than the applicable federal rate (“AFR”) or no interest is charged, the seller is considered to have received “imputed” taxable interest equal to the AFR.

Each payment received in an installment sale consists of three components:

  1. Interest income
  2. Return of basis
  3. Gain on the sale

Not All Sales Qualify as Installment Sales

Certain sales do not qualify as installment sales, including:

  • Sale of inventory items
  • Sales made by dealers in the type of property being sold (see my blog, Investor vs. Dealer)
  • Sale of stocks or other investment securities
  • Sales that result in a loss

Combining Installment Sales with Like Kind Exchanges

Like Kind Exchanges (§1031 exchanges) are often combined with seller financing of the relinquished (sold) property. This creates an opportunity for an installment sale transaction in which a promissory note, issued by the buyer for the benefit of the seller, represents a portion of the purchase price.

For example, if the relinquished property value is $1 million, the taxpayer (via a qualified intermediary) might receive $500,000 in cash and a $500,000 promissory note from the seller. The taxpayer/seller would ideally use the $500,000 proceeds in a tax-deferred exchange, while also benefiting from installment sale reporting on the remaining $500,000 note.

An installment sale is an option for taxpayers to spread a tax liability over time and collect interest income. However, it can carry risk for the seller. If the buyer is unable to make timely payments, the seller would be responsible for the costs of foreclosure and repossession.

Your tax professional can help you determine the tax effects of any installment sales arrangements you may have. As always contact me at [email protected] if you have any questions.