Gains and Losses
Calculation of Gain or Loss
The fundamental formula for determining gain or loss on the sale or disposition of property is:
Amount Realized
The amount realized is the total value received by the seller in the transaction. It includes:
- Cash received
- FMV of any property or services received
- Any liabilities assumed by the buyer (e.g., the buyer takes over the seller's mortgage)
- Reduced by selling expenses (commissions, legal fees, transfer taxes)
Adjusted Basis
The adjusted basis is the taxpayer's investment in the property, modified over time:
Example: Bear Co. sells a warehouse for $500,000 cash. The buyer also assumes Bear Co.'s $200,000 mortgage on the property. Bear Co. pays $30,000 in selling costs. The original cost of the warehouse was $450,000, and Bear Co. has claimed $120,000 in depreciation.
- Amount realized = $500,000 + $200,000 − $30,000 = $670,000
- Adjusted basis = $450,000 − $120,000 = $330,000
- Gain = $670,000 − $330,000 = $340,000
Character of Gain or Loss
The character of a gain or loss determines how it is taxed. The two primary categories are capital and ordinary (noncapital).
Capital Assets
A capital asset is defined by exclusion — it is any property held by the taxpayer except for the items specifically excluded by IRC §1221. In general, capital assets include:
- Stocks, bonds, and other investment securities
- Personal-use property (home, car, furniture)
- Land held as an investment
Noncapital Assets
The following are specifically excluded from capital asset treatment under §1221:
| Noncapital Asset | Example |
|---|---|
| Inventory or property held for sale to customers | Merchandise in a retail store |
| Accounts receivable from services or inventory sales | Amounts owed by customers |
| Depreciable property and real property used in a trade or business | Equipment, buildings, machinery (these are §1231 assets, subject to special rules) |
| Self-created copyrights, literary/artistic compositions | A novel written by its author |
| U.S. government publications received at a reduced price | Tax forms obtained at below-market rates |
| Supplies used or consumed in a trade or business | Office supplies, cleaning materials |
Property used in a trade or business (§1231 property) is not a capital asset, but net §1231 gains receive long-term capital gain treatment. This is often called "the best of both worlds" — gains are taxed at capital rates, but losses are fully deductible as ordinary losses.
Holding Period for Inherited Property
Inherited property automatically gets a long-term holding period under federal tax law. This means the holding period is treated as if it's more than one year, regardless of how short the actual holding periods were.
Example
The parent held shares for 3 months before death, then the estate held them for 2 months, and finally the taxpayer held them for 1 month before selling. Adding these up (3 + 2 + 1 = 6 months) does not matter.
Key Rule
Property acquired from a decedent is always treated as long-term property for capital gains purposes, even if the actual holding period is less than one year.
Why This Matters
This rule benefits the taxpayer because long-term capital gains are generally taxed at a lower rate than short-term gains.
The taxpayer's holding period is deemed to be more than one year, making any gain on the sale of inherited property a long-term capital gain.
Individual Capital Gain and Loss Rules
Holding Period
The holding period determines whether a gain or loss is short-term or long-term:
- Short-term: Property held for one year or less
- Long-term: Property held for more than one year
The holding period begins the day after the acquisition date and includes the day of disposition.
Tax Rates for Long-Term Capital Gains
| Rate | Applies To |
|---|---|
| 0%, 15%, or 20% | Regular long-term capital gains (rate depends on taxable income bracket) |
| 25% | Unrecaptured Section 1250 gain (depreciation recapture on real property) |
| 28% | Collectibles (art, antiques, coins, stamps) and §1202 qualified small business stock gain |
| 3.8% | Net Investment Income Tax (NIIT) — an additional surtax on higher-income taxpayers |
Short-term capital gains are taxed at ordinary income rates.
Net Capital Loss Deduction
If a taxpayer's capital losses exceed capital gains for the year, the taxpayer may deduct up to $3,000 ($1,500 if married filing separately) of the net capital loss against ordinary income.
Any unused capital loss is carried forward indefinitely to future years, retaining its character as short-term or long-term.
Example: Jamie has $2,000 in short-term capital gains and $12,000 in long-term capital losses during the year. Net capital loss = $10,000. Jamie deducts $3,000 against ordinary income this year and carries forward the remaining $7,000 as a long-term capital loss to next year.
Netting Capital Gains and Losses
For non-corporate taxpayers, the Internal Revenue Code requires a highly specific, multi-step netting process for capital gains and losses. Because capital gains are taxed at different preferential rates depending on the nature of the asset and the holding period, taxpayers cannot simply lump all their gains and losses together.
Instead, gains and losses must be separated into distinct "rate buckets" and netted in a prescribed statutory order.
The Capital Gain "Rate Buckets"
Before any netting between categories can occur, you must first group all transactions for the year into their respective rate groups and net them internally:
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Short-Term Bucket (Ordinary Rates): Capital assets held for one year or less.
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28% Bucket: Long-term gains and losses from collectibles (e.g., art, antiques, vintage comic books, rare coins) and Section 1202 qualified small business stock.
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25% Bucket: Unrecaptured Section 1250 gain (applies to depreciation taken on real estate).
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0/15/20% Bucket: Regular long-term capital gains and losses (e.g., standard stock investments held for more than a year).
The Cross-Bucket Netting Rules
Once you have a net gain or loss inside each specific bucket, you must offset any net losses against the net gains in other buckets.
The most heavily tested rule on the exam is how to apply a Net Short-Term Capital Loss (NSTCL). To maximize the taxpayer's tax benefit, the IRS requires that you offset an NSTCL against the highest-taxed long-term gains first.
The Offsetting Order for a Net Short-Term Capital Loss:
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First, apply the NSTCL against any net gain in the 28% bucket (Collectibles).
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Second, apply any remaining NSTCL against any net gain in the 25% bucket (Unrecaptured Sec. 1250).
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Finally, apply any remaining NSTCL against the 0/15/20% bucket (Regular Long-Term).
If an overall net capital loss remains after all offsetting is complete, the taxpayer can deduct up to $3,000 of that loss against ordinary income for the year, carrying the remainder forward indefinitely.
Application in Practice: The Offsetting Scenario
Let's walk through exactly how these ordering rules play out on a tax return.
Scenario: During the current tax year, an individual taxpayer recognized the following capital transactions:
Short-term capital loss: $50,000 (from day-trading tech stocks)
Collectibles gain: $40,000 (from the sale of a vintage guitar collection)
Regular long-term capital gain: $25,000 (from the sale of mutual funds held for three years)
Question: What is the taxpayer's final reported net gain or loss, and at what applicable tax rate?
Step 1: Identify the Buckets
- Short-Term Bucket: ($50,000) Net Loss
- 28% Bucket: $40,000 Net Gain
- 0/15/20% Bucket: $25,000 Net Gain
Step 2: Apply the Net Short-Term Capital Loss
We have a $50,000 NSTCL that we need to absorb. Following the statutory order, we must apply this loss to the highest-taxed long-term gains first.
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Absorb the 28% gains: Apply $40,000 of the short-term loss against the $40,000 collectibles gain.
Result: The collectibles gain is wiped out ($0 remaining). We still have $10,000 of our short-term loss left over ($50,000 total loss - $40,000 used).
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Absorb the 0/15/20% gains: Take the remaining $10,000 short-term loss and apply it against the regular long-term capital gain of $25,000.
Result: $25,000 gain - $10,000 loss = $15,000 remaining gain.
Conclusion: The taxpayer will report a net long-term capital gain of $15,000, which will be taxed at the preferential 0%, 15%, or 20% rate.
:::caution Common Pitfall
A common mistake is to either deduct the maximum $3,000 loss immediately without netting against the long-term gains, or to offset the regular 15% gains before the 28% gains. Always wipe out the 28% bucket first!
:::
C Corporation Capital Gain and Loss Rules
C corporations follow different rules for capital gains and losses than individuals.
Key Differences from Individuals
| Feature | Individuals | C Corporations |
|---|---|---|
| Short-term vs. long-term distinction | Yes — different tax rates apply | No — all capital gains taxed at the ordinary corporate rate |
| Net capital loss deduction against ordinary income | Up to $3,000 per year | Not allowed — capital losses can only offset capital gains |
| Capital loss carryback | Not allowed | 3-year carryback |
| Capital loss carryforward | Indefinite, retains character | 5-year carryforward, treated as short-term regardless of original character |
Example: Kingfisher Industries (a C corporation) has $50,000 in ordinary business income and a net capital loss of $20,000 this year. Kingfisher cannot deduct any of the $20,000 against ordinary income. Instead, Kingfisher carries the loss back 3 years to offset capital gains in those years. Any remaining unused loss carries forward for up to 5 years as a short-term capital loss.
A C corporation's net capital loss never reduces ordinary income. This is one of the most commonly tested distinctions on the REG exam.
Personal Residence Gain Exclusion
IRC §121 — Exclusion of Gain on Sale of Principal Residence
When an individual sells a principal residence, a significant portion (or all) of the gain may be excluded from income if certain requirements are met.
Ownership and Use Test
The taxpayer must have owned and used the property as a principal residence for at least 2 of the 5 years preceding the sale. The 2 years of ownership and 2 years of use do not need to be consecutive.
Exclusion Amounts
| Filing Status | Maximum Exclusion |
|---|---|
| Single, Head of Household, or Married Filing Separately | $250,000 |
| Married Filing Jointly (both spouses meet the use test) | $500,000 |
The exclusion may be used once every 2 years.
Example: Derek and Priya, a married couple filing jointly, purchased their home 7 years ago for $350,000 and lived in it as their principal residence for the entire period. They sell it for $900,000, realizing a $550,000 gain. They exclude $500,000 of the gain and report only $50,000 as a long-term capital gain.
Partial Exclusion
If a taxpayer does not meet the full 2-of-5-year requirement due to a change in place of employment, health reasons, or unforeseen circumstances, a partial exclusion may be available. The partial exclusion is calculated as:
The §121 exclusion applies only to gains. A loss on the sale of a personal residence is not deductible because the home is personal-use property.
Nondeductible Losses (WRaP)
Certain losses are specifically disallowed by the tax code. A helpful mnemonic is WRaP: Wash sales, Related party losses, and Personal losses.
Wash Sales — IRC §1091
A wash sale occurs when a taxpayer sells a security at a loss and purchases substantially identical securities within a window of 30 days before or 30 days after the sale (a total 61-day window).
Effect: The loss is disallowed, but it is not permanently lost. The disallowed loss is added to the basis of the replacement securities.
Example: On November 10, Sarah sells 100 shares of BIF Partners stock for $4,000, realizing a $3,000 loss (basis was $7,000). On November 25 — within 30 days — Sarah buys 100 shares of the same BIF Partners stock for $4,500.
- The $3,000 loss is disallowed under the wash sale rule
- Sarah's basis in the new shares = $4,500 + $3,000 = $7,500
- Sarah's holding period for the new shares tacks on from the original purchase date
The wash sale rule applies only to losses, not to gains. It applies to stocks, bonds, options, and mutual funds — but not to real estate or other non-security assets.
Related Party Losses — IRC §267
Losses on sales or exchanges of property between related parties are disallowed. Related parties include:
- Family members (siblings, spouse, ancestors, lineal descendants — but not aunts, uncles, or cousins)
- An individual and a corporation in which the individual owns more than 50%
- Two corporations that are members of the same controlled group
- A taxpayer and a trust of which the taxpayer is a beneficiary
- Other related-party combinations defined in §267(b)
Benefit to the buyer: If the related-party buyer later sells the property to an unrelated party at a gain, the buyer may use the previously disallowed loss to reduce (but not create) a loss on that subsequent sale.
Example: Marcus sells land to his daughter Priya for $60,000. Marcus's adjusted basis was $80,000, resulting in a $20,000 loss. The loss is disallowed because Marcus and Priya are related parties.
Later, Priya sells the land to an unrelated buyer for $90,000. Priya's realized gain is $90,000 − $60,000 = $30,000. Priya may offset $20,000 of Marcus's disallowed loss, reporting only a $10,000 gain.
If Priya instead sold for $65,000, her gain would be $5,000. She can offset $5,000 of the disallowed loss, reporting $0 gain. The remaining $15,000 of disallowed loss is permanently lost.
Personal Losses
Losses from the sale of personal-use property (property not held for investment or used in a trade or business) are not deductible. This applies to items such as:
- Personal residence
- Personal automobile
- Furniture, clothing, jewelry used personally
If personal-use property is sold at a gain, the gain is taxable. The nondeductible rule applies only to losses. This asymmetry is a favorite exam topic.
Example: Jamie sells a personal boat for $5,000. The original cost was $12,000. The $7,000 loss is nondeductible. If Jamie instead sold the boat for $15,000, the $3,000 gain would be a taxable capital gain.