Capital gains, as the name suggest, refer to gains from the sale of a specific investment. It is the difference between the selling price and the acquisition cost of a particular investment. The assumption here is that the selling price is higher than the acquisition cost. But if the acquisition cost is higher than the selling price, the result is capital loss which of course nobody wants to have. Investments include mutual funds, stocks, bonds, options, real estate, precious metals and collectibles.
For tax purposes, there are two classifications of investments which are based on the holding period. One is short-term if you hold the investment for a year or less and the other is long-term if it takes more than a year but less than five years. The factors in determining holding period are the acquisition and disposal dates of investment. It is vital to know the holding period of the investment as the tax rates applicable on the capital gains for each type varies.
In U.S. taxation, the treatment for long-term investment is quite better than the short-term counterpart. Its main advantage is having a lower tax rate. The tax rate applicable for long-term capital gains is usually lesser than the ordinary tax rates. And this is also dependent on your marginal tax bracket. It is either 0%, 15%, or 20%. Short-term gains are taxed in the same manner as ordinary income is taxed. In the year 2013, the tax rates ranged from 10% to 39.6%.
It is also important to understand the difference between unrealized and realized gains. Unrealized gains, also known as paper profits, occur when the value of your investment has increased but you have not sold it yet. And this is not part of the computation of capital gains tax. Gains are considered realized only when the investments are sold. This should be emphasized since capital gains are taxed only when these are realized. Most taxpayers prefer to defer the sale of their investments and prolong the holding period. Their purpose is to qualify for the lesser capital gains tax for long-term investments.
To keep track of all your investments, have an organized record-keeping of all the transactions related to it. Having a spreadsheet for this purpose makes the task easier. This is important for you to determine both the amount of realized and unrealized capital gains. Have a record of the type of investment you bought, acquisition date and cost, and any brokerage fees and commissions too. And when you sell your investment, make sure to take note of the date of sale, the gross proceeds, and any fees or commissions you paid to sell. You should also keep hold of any reports and trade confirmations along with any tax-related documents. With this, you will not have a hard time preparing your tax return.
Using the Schedule D and Form 8949, report all the capital gains or losses resulting from the sale of investments. Use the Qualified Dividends and Capital Gain Tax Worksheet in calculating the federal income tax. You can find this worksheet in the Instructions for Form 1040. Record all the individual transactions on Form 8949. Make a summary of the total figure from Form 8949 on Schedule D and transfer this to Form 1040. With all the essential information recorded in Form 8949, determining the total gains or losses will be easier. Then, you will be able to find out if you have a net profit or net loss out of your investments.