Unrealized Capital Gains Tax – A Quick Guide

Lately there has been some news that some leaders in the United States are considering changing how capital gains are taxed.  Specifically, there has been some discussion about taxing unrealized capital gains.  This article will shed some light on what unrealized capital gains are.

What is Unrealized Capital Gain?

Unrealized Capital Gain is any appreciation you have for a capital asset that you still own. Anytime you see the word unrealized, it means that you have not made any actual gains, yet, and the gains are only on paper. In other words, Unrealized Capital Gains are assets you own that have gone up in value, but have not been sold, yet.

An example of Unrealized Capital Gain can be a house that you purchased but live in, that has appreciated (gone up) in value. Let’s see how the numbers work. If you bought a house for $200,000 and now the house is worth $300,000. The difference of $100,000 is Unrealized Capital Gain. 

Another example of Unrealized Capital Gain is stocks you may have owned for over 12 months. Let’s say that a year ago you bought 100 stocks at $10 for a total of $1,000. Today, that stock is priced at $25 so the total value of 100 stocks is $2,500. You are still holding these assets and do not want to sell them.  The difference between today’s value and what you paid is called Unrealized Capital Gain. In this case, Unrealized Capital Gain is $1,500.

When is Capital Gains Taxed?

Under current laws, capital gains are only taxed when realized. This means that capital gains are only taxed when it is sold. Let’s say that you bought your house at $200,000 and sell it for $300,000. The difference of $100,000 is taxable when the sale is completed. Usually, Capital Gains are taxed at a lower rate than earned income because the capital asset (in this case the house) was purchased with after-tax money. The same is true when we talk about stocks. If stocks are held for longer than 12 months after purchase then sold at a profit, the gains are usually considered Capital Gains. In our example above, if you bought 100 stocks at $10 and sold the same 100 stocks at $25 one year later. The $1,500 gain on this sale is considered capital gains and is taxed at the Capital Gains rate.   

 

What is the Proposed Unrealized Capital Gain Taxes?

The new suggested tax by Treasury Secretary Janet Yellen on Unrealized Capital Gains means that any stock gains during a calendar year would be taxed in one’s income tax filing by April 15.

Why is Taxing Unrealized Capital Gain a Potential Headache?

Taxing Unrealized Capital Gain is a big problem because assets fluctuate in value from minute to minute and day today. An asset might have gone up in value this year but goes down in value the following year. Will the taxes be refunded if this happens? Taxing Unrealized Capital Gains also means that properties like people’s homes will be taxed on appreciation. The problem with this is that many retirees who purchased homes earlier in their lives have seen normal appreciation of their assets. Now, in their retirement (and most likely) and living a fixed-income lifestyle, retirees will be faced with paying taxes on an appreciated asset. This can cause many elderly homeowners to lose their homes and require that they sell to cover their tax liability. 

There are many questions to consider when taxing Unrealized Capital Gains.

  1. How will it affect retirees who have stocks as part of their retirement account? Will they have to liquidate (sell) to cover the tax expenses?
  2. How about appreciation at your house?
  3. How about other capital assets that appreciate over the year?
  4. How will depreciation on a capital asset work?
  5. What happens to a Capital Asset that appreciates this year and depreciates next year? Will the government refund the money?

As you can see, many questions should be raised and answered before a law can be enacted because the economic effect of taxing Unrealized Capital Gains can be much greater than anyone can predict.

What are Realized Capital Gains?

There are two types of Realized Capital Gains: Short-term Capital Gains and Long-term Capital Gains.

Long-term Realized Capital Gains are profits made on sales of capital assets that have been held for over 1 year. This includes most assets not limited to real estate, stocks, investments, collectibles, etc. Realized Capital Gains are usually taxed at a lower rate than regular earned income because the money used to make the purchase is usually after-tax money.

Short-term Realized Capital Gains are usually taxed at regular income tax rates and applied for assets purchased but not held for over a year. For example, if you purchase a house on January 1 and sell the house on December 1, the profit made on the sale is considered taxable income and does not benefit from the lower capital gains tax rate. Short-term Realized Capital Gains tax is higher than Long-term Capital Gains Tax.

What is Long Term Capital Gains Tax Rate?

Capital Gains tax rate fluctuates depending on your income and filing status. As of this writing, Long-term Capital Gains Tax can be up to 20% for individuals making over $445,850. For Short-term Capital Gains, the rate is up to 37% for individuals making over $523,600.

Do States Have Capital Gains Taxes?

Some states have Capital Gains Taxes. At 12.3% for individuals making over $599,012, California has the highest Capital Gains Tax for any state in the nation. 

Before making any financial moves, one should always consult with your tax accountant.

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