Doctrine of recovery of capital [as I discuss on my previous post: Important Tax Principles and Concepts], is the idea of gains and losses. That is, only the net gain or loss from the sale of property is taxable (or deductible) for income tax purposes in virtually every jurisdiction. How is capital gain or loss computed and taxed? This post shows you how.
Gain or loss is computed as:
Capital Gain or loss = Amount realized [the value of what is received] – Adjusted basis of property given
The adjusted basis of the property given is computed as:
Adjusted basis = Original basis + Capital improvements – Accumulated depreciation – Other recoveries of investments [such as write offs for casualty losses]
The original basis usually is the original purchase price. Capital improvements are additions that have an economic life beyond one year. Accumulated depreciation applies only in the case of an asset used in business.
A corporation buys a factory building for $2 million in year 1. It sold the building for $3 million in the current year. At the time of sale, the building had $600,000 of accumulated depreciation. In year 8, the corporation spent $400,000 on a new roof. The gain is:
Amount Realized: $3,000,000
Original basis $2,000,000
Add: capital improvements $ 400,000
Less: accumulated depreciation $ (600,000)
Net gain $1,200,000
As noted, in the U. S. gains and losses can be capital or ordinary. Capital gains and losses result from the sale of capital assets, which are defined as any asset other than inventory, receivables, long-term business fixed asset, and self-constructed assets. All other assets are ordinary and create ordinary gains and losses.
As a practical matter, corporations pay the same tax rate (their normal rate) on ordinary and capital gains. However, losses are treated differently for corporations. Ordinary losses are deductible without limit, while net capital losses are not deductible and must be carried back three years, and if still unused, forward five years.
A corporation sells a machine for $10,000. It had previously bought the machine for $20,000. At the time of sale, it had $6,000 of accumulated depreciation. This results in:
Amount Realized: $10,000
Less: Adjusted basis:
Original basis $20,000
Less: accumulated depreciation $ (6,000)
Ordinary loss ($ 4,000)
If the corporation is in the 35% bracket, the tax benefit is (0.35)($4,000) = $1,400. How would the answer change if instead there was a $4,000 gain? Because it is ordinary, the gain would be taxed at the 35% tax rate for a total tax effect of $4,000(.35) = $1,400 of tax.
A corporation sells the stock of a subsidiary for $20 million. It originally bought the stock of the subsidiary for $5 million. The difference is a $15 million capital gain, which is taxed at the 35% rate. What if there was a $15 million loss on the sale of the stock? Then, unless the corporation had other capital gains against which to offset the loss, the loss would be carried back three years to offset any possible capital gains in that year.
Multiple gains and losses must be separated into capital versus ordinary. Next, ordinary gains and losses are netted with each other. Separately, capital gains and losses are also netted with each other. Within the capital category, they must be segregated into short term versus long term. As a practical matter, this long- and short-term distinction does not matter for corporations, since the tax effect is identical.
The distinction does matter for individual taxpayers, since there is a preferential tax rate for long-term capital gains (i.e., gains on assets that have been owned by the taxpayer for more than one year).
A corporation has these transactions during the year: a long-term capital gain of $100, a short-term capital loss of $1,000, a short-term capital gain of $200, an ordinary loss of $300, and an ordinary gain of $500. The “netting“ process is:
Short Term Long Term
($200) ($1,000) $100
$ 500 $ 200 —
Net $300 ($800) $100
The net ordinary income of $300 will be taxed at the 35% rate. The net capital loss of $700 cannot be deducted in the current year, and instead will be carried back three years.
Assume the same facts as the previous example, except that the taxpayer is an individual. The ordinary income would be taxed at the taxpayer’s top rate. The net capital loss would be deductible at the taxpayer’s ordinary rate (individuals can deduct up to $3,000 per year).
What if there was a $700 net gain instead? If the gain was attributable to long-term assets, then the preferential long-term capital gains tax rate would apply. If the net gain was primarily from short-term assets, then it would be taxed at ordinary income tax rates.