Capital Gains and Losses - Research Paper Example

Capital gains and losses Introduction For many years, the United s capital gains and losses have continued to be plagued by many tax issues. Mutual funds are characterized by many unfavorable tax rules. First, there are inefficiencies where capital losses are deducted, and capital gains realized on trades within mutual funds. Earnest & Young (2011) argues that the United States has one of the most complex tax systems in the world. In the United States, there is no value-added tax or stamp duty imposition. However, every person and organization is subject to income taxation. As a rule, income must be reported, and taxes calculated and paid. Other than inventory items, companies may end up in selling other assets. If the ‘other’ assets generate gains or losses, they are referred to as capital gains or capital losses (Hammer, 2013). A capital gain is, therefore, the profit realized by an investor from selling an asset at a higher price than he bought it.1 Companies may also decide to exchange assets in the absence of tax-free exchange rules. In such an exchange, capital gains or losses may be incurred. Capital gains receive a more favorable treatment compared to other types of income. According to Weltman (2011), tax law is more favorable on all incomes categorized as capital gains. Tax law also provides a special treatment for capital losses. Capital gains and losses are realized from capital assets. All property except inventory accounts receivable from the sale of inventory, depreciable property such as telephones, U.S. government publications, and real property used in the business are treated as capital assets. Most properties that one owns and uses for personal purposes or investments are considered to be capital assets. Examples of capital assets include cars, furniture, stocks, bonds, and houses. During the transfer of assets, if the amount received for the asset exceeds the adjusted basis of the property, a gain is recorded. If the amount received from the buyer is less than the adjusted basis of the property, a loss is recorded (Weltman, 2011). In order for the company to record either a capital gain or a capital loss, an exchange must occur. Though it may take hundreds of pages to define the tax code and limit what may be accounted for as capital gain or loss, the basic idea is simple. A capital gain is the increase in value of a capital asset. Cordes, Ebel & Gravelle (2007) define capital gains as the changes in value of capital assets such as real estate, business interest, or corporate stock. Classification of capital gains and losses Gains and losses can either be classifiable as ordinary or capital gains or losses. They are further classified as either short term or long term.2 The correct classification and identification helps a person or a company to figure the correct tax on capital gains and the correct limit on capital losses. Short-term and Long-term capital gains and losses Tax on capital gains is paid to U.S. Federal Income Tax just as it applies to other sorts of income. Long-term capital gains are not taxed the same way with the short term gains. Capital gains and losses are said to be short-term if the holding period is one year or less. If the holding period of capital gains or losses exceeds one year, the capital gain is considered to be long-term (Hammer, 2013). The instructions about short-term and long-term capital gains are laid down in Form 8949 of the U.S. tax codes and regulations. Capital gains taxation Capital gains are usually taxable only when realized. Taxation of capital gains is a controversial matter because estimating the values of many assets would be difficult. Whereas taxation of unrealized income would seem unfair, taxation upon realization leads to other problems that require policy compromises. Historically, capital gains were taxed like any other form of income. Taxpayers objected to this form of taxation because a single transaction could represent years of deferred income. As a result, the realization of a capital gain could push people who were not supposed to be taxed in very high tax brackets. Tax brackets were reduced from eleven to three and ended the practice of excluding a portion of long-term capital gains from income with the passage of Tax Reform Act of 1986 (TRA86). Since then taxation of capital gains and losses has been subject to several reforms. Through the support of Congress, the rates were reduced by the passage of Taxpayer Relief Act of 1997 (TRA97) (Burman, 1999). For example, long-term gains in the 15 percent tax brackets were taxed at 10 percent whereas the gains in higher tax brackets were taxed at 20 percent. The rates were further reduced in 2003, where capital gains in the 15 percent bracket were taxed at 8 percent. The capital gains in the brackets above 28 percent on assets held for at least five years were also taxed at 18 percent rate. The tax rates on capital gains and dividends were further reduced following the Jobs and Growth Tax Relief Reconciliation Act of 2003. Economic issues in capital gains taxation Tax reduction on capital gains is proposed as a policy that can increase savings and investment. This reduction would provide a short-term economic stimulus and boost long-term economic growth. i. Lock-in Effect The current system of taxation of capital gains is considered defective because of a “lock-in effect”. As a rule, capital gains are taxed only when realized. However, it becomes unlikely to realize capital gains due to the high capital gains tax rates. Most companies find themselves realizing capital losses instead. According to Cordes, Ebel & Gravelle (2007), investors who would prefer to sell the appreciated asset are discouraged by these rates and they are said to be “locked in”. This situation is worsened by the non-taxation of capital gains at death. The lock-in effect stimulates many schemes that allow people to gain access to the cash value of large investment without technically selling them. As a result, laws are enacted to discourage them and they end up complicating the lock-in effect further. ii. Inflation Capital gains are defined in nominal terms, and this creates another problem because they are not indexed for the effect of inflation. The effective rate on real capital gains is raised by taxing the nominal gains. This effect imposes a tax in cases of real economic losses. According to Cordes, Ebel & Gravelle (2007), past studies have demonstrated that a large percentage of reported capital gains reflect the effects of inflation. iii. Deferral From an economic perspective, when taxes on capital gains are deferred until realization, the present value of the tax is reduced. This deferral reduces the effective tax rate below the statutory tax rate. The combination of inflation and deferral produces an effective rate that is higher or lower than statutory rates. Behavior responses and revenue There is complexity in the way capital gains respond to tax rates. When there are no changes in tax law, the taxpayers are induced by the fluctuations of income to accelerate or defer realizations of gains. Cordes, Ebel & Gravelle (2007) observe that taxpayers may also time realization to take advantage of differential tax rates. Statutory changes in tax laws may trigger both short-run and long-run responses. In addition, if the taxpayers anticipate an increase in capital gains tax rates, they are likely to accelerate the realization of capital gains. Taxpayers will defer the realization in case they anticipate a reduction in capital gains tax rates. There are other behavior responses that the taxpayers can exhibit such as income conversion. Due to preferential tax rates for capital gains, taxpayers can be induced to convert ordinary income, shifting to capital gains that are taxable at a lower rate. The compensation awarded to the executive may be shifted from salaries to capital gains. This shift of compensation is a common type of behavior among the taxpayers in response to capital gains. Capital Losses Capital loss is not usually deductible on the sale of property held for personal use. These properties may include a car or a vacation home. Capital losses are often used to offset capital gains. However, there is a need for a limit to which capital losses can be deductible. This limit is required to prevent taxpayers from tax offsets through recognition of capital losses and not capital gains. As a requirement, capital losses can be carried forward five years and carried back three years solely to offset capital gains (Earnest & Young, 2011). However, there is an exception to this. If the capital loss creates or increases the net operating loss, the carry-back cannot be availed. In “Section 382 limitation”, the potential abuse of loss deductions is addressed by the IRC. Section 382 limits the amount of income that NOL carryover can offset after an exchange. Due Section 382 limitations, some losses are not deducted in a particular tax year. On such occasions, losses can be carried forward. Hammer (2013) argues that investors can use tax loss harvesting as a strategy for reducing their tax liability. They first use it to offset taxable gains and secondly; they use in reducing taxable ordinary income up to $3,000 per year. In case the investor was planning to dispose of the investment, he will realize double benefit. Netting losses against gains The losses that are incurred after the sale of an asset/investment held in taxable accounts may be deducted first from the gains. The procedure of deducting losses from the gains is referred to as “netting” (Hammer, 2013). The procedure may not be effective if the investor does not target netting both the gains and losses. In order to realize additional tax benefits, the investor should use tax loss harvesting on a regular basis. Hammer (2013) argues that tax loss harvesting is a useful tool for reducing tax liability. However, she advises that the main focus should be maintained on the overall investment, tax planning, and wealth management. Distribution of the tax burden The distribution of income tax has been a topic of intense debate since the introduction of taxation on capital gains. This has prompted the key stakeholders to make several time-to-time reforms on the existing laws and regulations. According to Cordes, Ebel & Gravelle (2007), capital gains are highly concentrated among the high-income households compared to other forms of income. Therefore, it is argued that cuts on capital gains cut would not do much good. The Federal government taxes capital incomes in different ways. There are three federal income tax rates that apply to almost all net long-term capital gains. These rates were found to be applicable in the tax year 2014. The tax rate of zero percent was effective for the taxpayers in the 10 percent of 15 percent bracket. This group represents the taxpayers who receive below $73,800. The tax rate of 15 percent was applicable for taxpayers above the 15 percent bracket but below 39.6 percent bracket. This group of taxpayers receives between $73,800 and $457,600. The last group of taxpayers attracts a 20 percent tax rate. This group falls in the top bracket of over 39.6 percent and these taxpayers receive $457,600 and higher. Conclusion A common argument is that the reduction of tax rate on capital gains would increase tax revenues by triggering a dramatic increase in capital gains realizations. While the discussions, research and debates on changes in capital gains tax continues to intensify the already available evidence suggests that the reduction of capital gains tax rate reduces tax revenues. The most substantial taxes on gains can be realized from the higher income households because they are more likely to own assets compared to lower –income households. Tax reduction on capital gains is proposed as a policy that can increase savings and investment. However, in a wide perspective, tax reductions on capital gains can have a negative overall impact on national saving because it would favor only the very high-income taxpayers. Capital gains tax reduction would both encourage a more active market in corporate stock as well as increase tax revenue. Economically, it has been argued that capital reductions have little or a negative effect on savings and investment. References Burman, L. (1999).The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed. Washington: Brookings Institution Press. Cordes, J., Ebel, R. & Gravelle, J . (2007).The Encyclopedia of Taxation & Tax Policy. Washington: The Urban Institute Press. Earnest & Young. (2014). Step by step, helping you succeed in the US: The inbound guide to US corporate tax. Earnest & Young. Retrieved from http://www.ey.com/Publication/vwLUAssets/EY_US_Inbound_brochure_en/$FILE/EY-US-Inbound-brochure-en.pdf Hammer, S. (2013). Glass half full: The silver lining of capital losses. The Vanguard Group Inc. Retrieved from www.vanguard.com/pdf/s802.pdf Weltman, B. (2011). J.K. Lassers Small Business Taxes 2012: Your Complete Guide to a Better Bottom Line. New Jersey: John Wiley & Sons. Read More