Any capital asset when sold can give the seller a higher or lower price from its purchase price leading to a capital gain or capital loss. The time period of holding an asset is decided based on if it is a long term or short-term capital gain. On that basis, the rate of taxation is decided if it is 20%, 15% or according to the tax brackets. The rate of taxation differs in the case of equity or debt, whether long or short term. The capital gain can be adjusted from capital loss to arrive at a net capital gain. The amount of gains and the exemption has to be reported in the tax return filed in the financial year in which the asset was transferred. The tax return can be filed quarterly, monthly, semi-annually or annually.
What is Capital Gain?
It refers to an increase in the value of a capital asset and the amount that is realized when the asset is sold off. A capital gain may be short-term or a long-term depending on the tenure for which the asset is held. A capital loss generally occurs when the market value of an asset decreases over a period of time as compared to its purchase price.
What is Capital Gains Tax?
A capital gains tax is generally levied on the growth in the value of investments incurred when individuals and companies sell their investments in a certain period of time. When such assets are sold, the gains so made are referred to as having been realized. The capital gains tax doesn't apply to any unsold investments or unrealized capital gains, hence the shares that appreciate every year will not incur any capital gains taxes until they are sold, no matter how long it has been held. Types of capital asset and capital gains tax is applicable on it.
The capital gains tax is categorized into two.
Long Term Capital Asset
These are the assets that are held for more than a year. For example, if any house property is sold after holding it for more than 24 months, it will be termed as a long-term capital gain (LTCG).
Short Term Capital Asset
These are the assets that are held for one year or less. In the case of immovable properties such as house, land, or building, the criteria are of 24 months or less. In the case of the following assets, they are considered short-term when held for 12 months or less.
Conditions for Attracting Tax on Capital Gain.
- There must be a capital asset owned by the seller.
- There must be a transfer of capital assets in the financial year.
- There must have been gain on the transfer of capital assets.
Tax on the long term and short-term capital gain (STCG)
- The tax rate on LTCG is normally 0%, 15%, or 20% depending on tax bracket.
- The LTCG tax rate on the sale of equity shares is 10% over and above 1 lakh
- Short term capital gain tax is taxed as ordinary income.
Calculation of Capital Gain
Below mentioned points need to be considered while calculating capital gain.
- Cost of acquisition: The price at which an asset was bought by the seller initially.
- Cost of improvement: Any expenses made in addition to any improvement in the asset.
- Full value consideration: Total amount received or to be received by the seller for transfer of property.
What is Net Capital Gain?
The "net capital gain" is defined as the difference between net long-term gain (long-term capital gains minus long-term losses and any unused capital losses carried over from prior years) and net short-term capital loss (short-term gain minus short-term loss). A net capital gain may be subject to a lower tax rate than the ordinary income tax rate.
Can Mutual Funds Lead to Capital Gains?
The mutual funds that have accumulated realized capital gains are generally distributed to the shareholders and often before the end of the calendar year. The shareholders receive the fund's capital gains distribution along with a 1099-DIV form detailing the amount of the capital gain distribution along with the details of the amount considered as short-term capital gain and long-term capital gain as of the fund's ex-dividend date. The distribution thus helps in reducing the mutual fund's net asset value (NAV) by the amount of the pay-out. However, it does not impact the fund's total return.
US Capital Gains Tax
It applies to profits from assets held for more than one year known as LTCG. There are three types of tax rates that apply depending upon the tax bracket, which are 0%, 15%, or 20%.
It applies to profits from assets held for less than one year known as STCG. They are taxed as ordinary income. Tax on a capital gain can be reduced by capital losses in the same year. Capital loss happens when an asset is sold below its acquisition price.
Net capital gain= LTCG – Capital loss
Advantages of Capital Gains
The advantage of capital gains is that tax payments are generally deferred until the asset is sold. For example, a real-estate investor does not have to pay taxes on the equity gained in a property investment until the year in which he sells the property for a profit. The investors pay taxes only during the tax year when they realize gain. It is different from income taxes where it is mandatory to pay tax each time payment is received.
Disadvantages of Capital Gains
A disadvantage of owning capital assets is that if they are sold for profit, the internal revenue service requires an individual to report such gains as income. The disadvantage of this tax is that it can reduce the overall profits realized from the sale of the asset.
Ways to Reduce Capital Gains Tax
- Waiting longer than a year before selling: In case where a company sells an asset, it generally makes a long-term or short-term gain. One of the advantages of gains that fall under the long-term status is that they attract lower capital gains tax rates which is one of the ways in which capital gains tax can be reduced.
- Sell when the income is low: The disposing of long-term capital gain assets during “lean” years meaning in the year when the income is low, it can help in reducing the capital gains tax; and the situations that may cause a decline in an individual’s income include approaching retirement period, quitting, or loss of employment. Therefore, selling the assets during such times can minimize the amount of tax levied.
- Timing capital loss with capital gains: The capital losses can be used to offset capital gains. For example, individual owns two types of stocks, A and B. When he sells stock A, he makes a profit of $90, but when he sells stock B, he makes a loss of $40. His net capital gain is the difference between his capital gain and loss, $50. Therefore, using losses in the year where an individual makes gains on capital can help him to lower the amount of tax significantly. It is to be noted that even though individuals are required to report all their capital gains, the tax to be levied is computed only on the net capital gain.
Context and Application
It is used and forms an important topic when the income tax topics ae covered in under-graduate and post graduate courses like
- Bachelor of Commerce
- Master of Commerce
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