CPA REG: Capital Gains and Losses Rules
Master capital gains and losses taxation for the CPA REG exam, including holding periods, tax rates, netting rules, capital loss limitations, and special asset categories.
Capital Gains and Losses: Essential REG Exam Concepts
Capital gains and losses arise from the sale or exchange of capital assets. The taxation of these transactions is one of the most frequently tested areas on the CPA REG exam. Understanding holding periods, applicable tax rates, netting procedures, and special rules is critical for exam success.
What Is a Capital Asset?
Under IRC Section 1221, a capital asset is defined by exclusion. All property is a capital asset unless specifically excluded. The excluded categories include inventory or property held primarily for sale to customers, depreciable property and real property used in a trade or business (Section 1231 assets), accounts or notes receivable acquired in the ordinary course of business, supplies, and certain self-created copyrights, literary, musical, or artistic compositions (unless the taxpayer elects capital asset treatment).
Personal-use assets such as a home, car, and furniture are capital assets. Investment assets such as stocks, bonds, and land held for investment are also capital assets. The exam frequently tests whether a particular asset qualifies as a capital asset or falls within one of the exclusions.
Holding Period Rules
The holding period determines whether a gain or loss is short-term or long-term. Property held for more than one year produces long-term capital gain or loss. Property held for one year or less produces short-term capital gain or loss. The holding period begins the day after acquisition and includes the day of disposition.
Special holding period rules that appear on the exam include: property received as a gift takes the donor's holding period if the donor's basis is used (tacked holding period); inherited property is automatically treated as long-term regardless of actual holding period; property received in a like-kind exchange includes the holding period of the relinquished property; and property received in a nontaxable corporate or partnership transaction takes the holding period of the transferred property.
Tax Rates on Capital Gains
Short-term capital gains are taxed at ordinary income rates. Long-term capital gains receive preferential rates: 0% for taxpayers in lower brackets, 15% for most taxpayers, and 20% for the highest bracket taxpayers. Additionally, the 3.8% net investment income tax under IRC Section 1411 may apply to capital gains of higher-income taxpayers.
Special rates apply to certain types of property. Collectibles (art, antiques, gems, stamps, coins, and precious metals) are taxed at a maximum rate of 28%. Unrecaptured Section 1250 gain on real property (the portion of gain attributable to straight-line depreciation on real property) is taxed at a maximum rate of 25%. Gain attributable to depreciation in excess of straight-line on personal property is recaptured as ordinary income under Section 1245.
Netting Capital Gains and Losses
The netting process is a multi-step procedure tested heavily on the REG exam. First, gains and losses within each rate group are netted. Short-term gains and losses are netted together, and long-term gains and losses are netted together. If there is a net short-term capital gain and a net long-term capital loss, they are combined. If there is a net short-term capital loss and a net long-term capital gain, they are combined.
The order matters because short-term gains are taxed at ordinary rates while long-term gains receive preferential rates. A net short-term capital loss first offsets the lowest-taxed long-term capital gains.
Capital Loss Limitations
Individual taxpayers may deduct net capital losses against ordinary income up to $3,000 per year ($1,500 for MFS). Any excess capital loss is carried forward indefinitely, retaining its character as short-term or long-term. There is no carryback for individual capital losses.
Corporations have different rules: corporate capital losses can only offset capital gains (not ordinary income), unused capital losses may be carried back three years and forward five years, and all corporate capital loss carrybacks and carryovers are treated as short-term.
Wash Sale Rule (IRC Section 1091)
A loss on the sale of stock or securities is disallowed if the taxpayer acquires substantially identical stock or securities within 30 days before or after the sale. The disallowed loss is added to the basis of the replacement stock, effectively deferring rather than permanently disallowing the loss. The holding period of the replacement stock includes the holding period of the sold stock. This rule applies to losses only, not to gains.
Related Party Sales (IRC Section 267)
Losses on sales between related parties are permanently disallowed. Related parties for individuals include family members (siblings, spouse, ancestors, and lineal descendants) and entities in which the taxpayer owns more than 50%. If the related buyer subsequently sells the property at a gain, the gain is reduced (but not below zero) by the previously disallowed loss. Gains on related party sales are recognized but may be recharacterized under IRC Section 1239.
Exam Strategy
- Always determine whether an asset is a capital asset before applying capital gains rules
- Calculate the holding period precisely, starting the day after acquisition
- Know the netting order for different rate groups
- Remember the $3,000 annual loss limitation for individuals and the carryforward rules
- Watch for wash sale and related party scenarios in multiple-choice questions
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