by Tiffany Lashmet for Texas A&M AgriLife Extension
I’ll offer the same two disclaimers as I have on the prior posts in this series. I am not a tax lawyer, CPA, or accountant. I’m here to offer just basic information, but highly recommend that you consult with your attorney and tax professional for further advice or clarification. Second, there has been a lot of talk from Washington, DC, about potential changes to some of these rules. The posts in this Talking Taxes series will explain the law as it currently is written and applied, but everyone needs to be sure to pay attention to any changes that could be forthcoming.
What are they? Capital gains taxes are a tax due when a person sells an asset that has appreciated in value. For example, if a person purchased land that cost $400/acre, and she sells it years later for $1,000/acre, capital gains taxes would be owed on the $600/acre increase in value that has occurred since the time she acquired the land. Capital gains taxes only apply to “capital assets” such as stocks, bonds, jewelry, collectibles, artwork, vehicles, and land.
Who pays it? Generally, the seller is responsible for paying the capital gains taxes owed. Importantly, note that capital gains taxes are only “realized” or owed when the asset is sold. If a person does not sell an asset, these taxes are not realized, no matter how much the value may increase.
How are capital gains taxes calculated? Capital gains taxes are broken into long-term capital gains and short-term capital gains. Long-term capital gains are owed on assets held for over one year. Long-term gains rates range from 0% – 20%, depending on a person’s tax bracket. Short-term capital gains are owed on assets held for less than one year. Short-term gains are taxed as ordinary income. Additionally, keep in mind that capital gains for a year may also be offset by capital losses for the same year. Capital losses occur when a person sells an asset for less than she paid for it. For example, say a person purchased Stock A and Stock B each for $100. Two years later, the person sells Stock A for $150 and Stock B for $50. The person’s net capital gain would be 0, and no capital gains taxes would be due for these stocks.
Do note that the cost basis can be adjusted up or down depending on certain situations. For example, if improvements are made to a capital asset, thereby increasing the value, the cost basis may also increase. Conversely, if a person depreciates an asset, that may decrease the cost basis for the asset as well. There are numerous specific details to consider here that are beyond the scope of this blog, so again, I recommend seeking advice from a licensed professional.
When are capital gains taxes due? Capital gains taxes are due by the normal tax deadline in the year following the sale of an asset.
What exemptions exist? There are certain exemptions to capital gains taxes. Here are a couple of key ones to consider.
First, a person’s primary home is considered a capital asset, but the IRS recognizes an exclusion on capital gains earned through the sale of a primary residence. The exclusion is $500,000 for couples filing jointly and $250,000 for a person filing as single.
Second, there are certain retirement plans such as 401(k)s, 403(b)s, Roth IRAs, and traditional IRAs that grow without being subject to capital gains taxes. This allows a person to buy and sell within a retirement plan without paying capital gains taxes.
Third, business inventory and depreciable business property is not subject to capital gains taxes.
What is a stepped up basis? One key concept related to capital gains taxes is that of a stepped up basis. This is particularly important for agricultural operations that have been passed from one generation to the next. If a step up in basis is allowed, it changes the cost basis for an asset. For example, say Mom purchased her land for $500/acre. When she died and left the land to her son in her will, it was worth $1,000/acre. The step up in basis would allow the cost basis for the land to increase from $500 to $1,000 when it was inherited by the son. Thus, if he sells the land and it is worth $1,500, he will owe capital gains taxes on $500 ($1,500 – $1000), rather than on $1,000 ($1,500 – $500). Importantly, with regard to transferring an asset at death, only those assets that are transferred at death, such as by will, by Transfer on Death Deed, or by Lady Bird Deed, for example, will qualify for the step up in basis. If the asset was transferred prior to death, there would be no stepped up basis allowed. To read more about the pros and cons of transferring property before death, click here.
What can be done to avoid capital gains tax liability? There are options for a person to avoid capital gains tax liability but, as we have said in the other posts, a person should consult with an attorney, accountant, and/or tax professional before selling an asset in order to fully explore these options. With regard to real property, one option to consider may be a 1031 Exchange, if the seller wishes to purchase like kind property with the proceeds from the sale. It is important to remember, however, that a 1031 Exchange does not completely eliminate the requirement to pay capital gains tax; rather, use of a 1031 Exchange enables a person to defer the tax liability from the sale of real property, until the new like kind property that is acquired in the exchange is later sold.
Where can I find more information? For more information, listen to this prior podcast episode I did with Pat Dillon. (Disclaimer–the audio quality was not the best, so I apologize, but the information is useful!)
What potential changes have been discussed? Recently, capital gains taxes have been in the news as modifications have been mentioned by President Biden and included in his American Families Plan. According to the White House summary of the American Families Plan, the capital gains tax rate would increase to 39.6% for households making over $1 million. The plan would also eliminate the stepped up basis for gains in excess of $1 million. The plan contains the following language, “The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs to continue to run the business.” Additionally, there had also been discussion of taxing unrealized gains at death, as opposed to only actual gains being realized when property is sold. This is a critical topic, especially for agriculture, so keeping an eye on any forthcoming changes will be critical.