The past year and its market successes -- and disappointments, depending on how well you played the market during a profitable yet volatile year -- are history, and now we are well into a new investment year. However, some important unfinished business remains: reporting the results of last year's investing on your income-tax return.
Interest and dividend income are fairly straightforward to declare. With capital gains, though, it's not so simple. When done properly, capital-gains reporting should include a review of your capital investing in past years. That's because you might be able to use capital losses incurred in any previous year to reduce the amount of your taxable capital gains in 2010, and to use capital losses incurred last year to offset gains realized during the previous three years.
A capital gain is a profit made from the sale of a capital investment, which typically is a stock, bond, mutual fund or real estate. Gains realized only on paper -- where an investment's value has grown, such as when a stock you own is trading at a higher price than what you paid for it -- are not included in your income.
You declare a taxable event only after you have actually sold a capital investment. This triggers a capital gain that must be reported on the tax return for the year in question. When calculating the gain from the sale of a bond or other fixed-income security, be sure not to include the amount of any interest paid to you from that investment. The gain generally is based only on the difference between what you paid for the bond and what you sold it for.
Things get more complicated when you consider that only one-half of capital gains are taxable, and that capital losses can be used to reduce the amount of taxable capital gains. What's more, losses realized during a previous year, but not yet used to reduce gains, can be carried forward to be used on a future tax return.
So if you have any unused capital losses from the market meltdown of 2008 that you did not use to offset any gains during 2009's equity boom, be sure to dredge them up to ease the tax burden on any gains you realized in 2010. Note than only one-half of capital losses can be used to reduce a taxable capital gain.
For example, consider an investor who lost $5,000 when he sold a technology stock in 2008. He stood pat with his portfolio during 2009, anticipating continuing market strength in 2010. Then, midway through last year he decided to lock in some of his profits by selling a resource stock, realizing a capital gain of $8,000. This left him with a net gain of $3,000 before tax.
The investor can apply one-half of 2008's capital loss, or $2,500, against 2010's taxable capital gain of $4,000 (one-half of the actual $8,000 profit). The taxable capital gain for 2010 thus is reduced to $1,500. Since he is in the 50% tax bracket, use of the previous capital loss will reduce his tax bill by $1,250. So he ends up paying tax of approximately $750 on his net capital gain of $3,000.
Capital losses can be used only to reduce taxable capital gains, not other types of income such as dividends, interest or wages from employment. However, realized capital losses can be carried forward indefinitely to be used to offset taxable capital gains in future years.
Capital losses on one type of investment can be used to offset capital gains on a completely different type of asset. For instance, consider someone who made a profit on the sales of an investment property such as a condominium that had been rented out. This individual could use capital losses realized on the sale of stocks to reduce the capital gain realized from the sale of the investment property.
Remember, the sale of a principal residence normally is not taxable, so capital gains and losses usually are not a factor. However, if you have more than one property that could qualify as a principal residence, some analysis is worthwhile, says Paul Hickey, a partner in KPMG's national tax practice.
"You and your spouse can only have one principal residence for a particular year," Hickey says. "So if you have more than one principal residence you may have to do some figuring to determine which one you want to designate as your principal residence for a particular year or years to maximize the benefit of your principal-residence exemption on the two properties."
When calculating a capital gain, you must include the costs of acquiring and disposing of the investment to determine the investment's adjusted cost base (ACB). For a stock, the ACB is the sum of the acquisition cost plus sales commissions.
Capital gains are reported on Schedule 3 of your tax return. You report your gross proceeds of the disposition in one column. In a separate column, you deduct the cost of sales commissions and any other outlays in connection with the sale. Subtract the costs of selling from the gross proceeds to arrive at your net capital gain or loss from that investment.
If you are in a fee-based account rather than one that charges fees based on transactions, the ACB would not be affected by trading costs. However, says Hickey, "the annual fees paid to your investment advisor for managing your investments would be fully deducted as an investment carrying charge on your tax return, in the same manner as, say, any interest expenses that you may have incurred on money borrowed to acquire your investments."
On the sale of a real-estate investment, the ACB similarly includes commissions and other expenses that you incurred related to the purchase or sale, such as the cost of having a land survey done. You also can increase the ACB by the amount of the cost of renovations and other capital improvements you made to the property during the time you owned it.
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