Tax time is right around the corner so now is a good time to review the sometimes complicated rules for calculating your taxable capital gains and losses. First, let's review the definitions of short term and long term. A short term investment is anything that you have held for a year or less. Most people think that a short term investment is something that you have held for less than a year, but this is not correct. An investment does not become a long term investment until you have held it for more than a year. When you are determining the holding period for your investment, the clock starts running the day after you purchase the asset and it ends on the day that you sell the asset.
If you hold an investment for more than a year and then sell it at a gain, the gain will be taxed at long term capital gains rates which are significantly lower than ordinary income tax rates. So, generally speaking, if you are close to meeting a long term holding period, it is best to wait to sell the asset. If you sell before you meet the long term holding period, any gains would be taxed at your ordinary income tax rate (which run as high as 35 percent in 2009).
But what happens if you gains on some assets and losses on others? And, further, what happens if some of the gains are long term and some are short term? Also, what happens with any losses you might have recognized?
The first step is to calculate the gain and loss for each investment. A gain or loss is what is left over after you subtract the purchase price (be sure to include any commissions paid) from the sales price. Then note which investments were held for more than a year and which were held for a year or less. Next, net all of your short term gains and short term losses. This will give you your overall short term gain or loss. Then, do the same thing for all your long term gains and losses. This will give you your overall long term loss or long term gain.
The final step is the netting of your short term and long term gains and losses. This is where people often make mistakes. If you have a net short term gain and a net long term loss and the short term gain exceeds the long term loss, the net gain is considered a net short term gain and the gain is taxed at ordinary income tax rates. If the net long term loss exceeds the net short term gain, the overall loss is considered long term and you can deduct up to $3,000 against your income and carry forward any excess to future years.
If your long term gain exceeds your short term loss, the net gain is considered to be a long term gain and that gain is taxed at the favorable long term capital gains tax rate. If the short term loss exceeds the long term gain, the overall loss is considered to be short term. In this case, you can deduct $3,000 of the loss against ordinary income and carry the unused loss into future years.
If you had net short term loss and a net long term loss, you can deduct up to $3,000 against ordinary income. In this instance, you would use your short term loss first when applying the $3,000 limit. As with the other scenarios, any unused loss is carried forward to future years (and the short or long term nature is kept).
These rules can be very confusing so if you need further assistance, check out IRS Publication 550 "Investment Income and Expenses"