Accountancy Resources
A capital asset can be almost anything that is owned or used for personal purposes. If this capital asset is sold, the difference between the final sale price and the base price (typically the amount you originally paid for the asset) will become a capital gain or a capital loss. If you sell the asset for more than you paid for it, you will realize a capital gain. Some common capital assets include your home, a family business, art, or collectibles.
The capital gains tax is perhaps one of the most contentious and debated portions of the US tax code. Under the Reagan administration, the Tax Reform Act of 1986 raised the maximum capital gains rate from 20% up to 28%.
Despite this increase, the revenue collected from the capital gains tax still did not amount to 3% of the total federal budget by 1992, making some critics wonder if the tax is truly necessary at all.
With the capital gains tax, one is legally obligated to report all capital gains (and thus pay tax) while only being able to deduct a percentage of capital losses—hence, the system is skewed and appears to punish risk-taking because all rewards or profits are taxed while losses are merely absorbed. But, while it may appear that the capital gains tax is little more than a tax penalty that punishes productivity and the accumulation of wealth, much depends on how the capital gain or loss is reported.
A capital gain (or loss) can be reported as either long-term or short-term, depending on how long the asset was held prior to liquidation. If an asset is held for more than a year prior to selling it, then it is a long-term capital gain or loss. For all assets acquired and liquidated within a year or less, the gain or loss will be considered short-term. Essentially, this means that this is a “voluntary tax” giving the taxpayer the ability to choose when the best time is to liquidate a particular asset.
A taxpayer can hold on to a particular asset for twenty-five years and not owe taxes until it is sold. Known as the “lock-in effect”, the ability to defer tax liability until the asset is sold tends to create an illusion of profits while simultaneously blocking billions of dollars from being reinvested into the economy. While a near-constant turnover of assets (such as with real estate or even equities) would create pricing volatility, holding onto assets and delaying tax liability prevents the utilization of capital while continually under-funding the tax system until the capital gain is finally realized. While the actual capital is still actively propelling the economy, the taxes do not enter into the system until the gain is realized.
In the United States alone, it is estimated that there is more than $7.5 trillion in unrealized capital gains. The capital asset may be an IRA so it is still helping to drive economic activity but applicable taxes on annual profits will only apply when the asset is sold and thus the tax system appears to have been “slighted” during the period between when an asset was purchased and when it is sold for capital gain. However, taxes are ultimately collected when the asset is realized so the “books do balance”. Even if the asset is not realized by the initial investor, surviving members of the estate would still be required to pay capital gains on investments; however, there remain some points of contention with respect to the capital gains tax, including:
Despite accounting for as little as 3% of total tax revenues, the capital gains tax continues to stir debate because of its connection with the “poor” vs. “rich” divide. Some argue that the tax discourages investment because it does not permit investors to fully deduct losses (only up to $1,500 if filing single) while all gains are taxed. Because it is possible to defer tax liabilities for several years, the effects of inflation may lead to “over-taxation” when the true purchasing power is taken into account. Despite these points of contention, however, the capital gains tax appears to be a permanent fixture in the tax code and is not likely to disappear any time soon.
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