How does the capital gains tax work?

Almost everything you own and use for personal purposes, pleasure or investment is a capital asset. # When you sell a capital asset, the difference between the amount you sell it for and your basis, which is usually what you paid for it, is a capital gain or a capital loss. # You must report all capital gains.

# You may deduct capital losses only on investment property, not on property held for personal use. # Capital gains and losses are classified as long-term or short-term, depending on how long you hold the property before you sell it. If you hold it more than one year, your capital gain or loss is long-term.

If you hold it one year or less, your capital gain or loss is short-term. # Net capital gain is the amount by which your net long-term capital gain is more than your net short-term capital loss. # The tax rates that apply to net capital gain are generally lower than the tax rates that apply to other income and are called the maximum capital gains rates.

For 2008, the maximum capital gains rates are 0%, 15%, 25% or 28%. # If your capital losses exceed your capital gains, the excess can be deducted on your tax return, up to an annual limit of $3,000 ($1,500 if you are married filing separately). # If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that next year.

2)Mutual funds vs ETF and how it is computed? General Tax Rules ETFs enjoy a more favorable tax treatment than mutual funds due to their unique structure. Mutual funds create and redeem shares with in-kind transactions that are not considered sales.

As a result, they do not create taxable events. However, when you sell an ETF, the trade triggers a taxable event. Whether it is a long-term or short-term capital gain/loss depends on how long the ETF was held.

In the United States, to receive long-term capital gains treatment you must hold an ETF for more than one year. If you hold the security for one year or less, then it will receive short-term capital gains treatment.It's not all doom-and-gloom for mutual fund investors. The good news is that a mutual fund's generally higher turnover of shares creates more chances for capital gains to be passed through to their investors, compared with the lower-turnover ETFs.

(To learn more about the advantages and disadvantages, check out Mutual Fund Or ETF: Which Is Right For You?) As with stocks, you are subject to the wash-sale rules if you sell an ETF for a loss and then buy it back within 30 days. A wash sale occurs when you sell or trade an security at a loss and within 30 days after the sale you: * Buy a substantially identical ETF, * Acquire a substantially identical ETF in a fully taxable trade, or * Acquire a contract or option to buy a substantially identical ETF If your loss was disallowed because of the wash-sale rules, you should add the disallowed loss to the cost of the new ETF. This increases your basis in the new ETF.

This adjustment postpones the loss deduction until the disposition of the new ETF. Your holding period for the new ETF begins on the same day as the holding period of the ETF sold. Many ETFs generate dividends from the stocks they hold.

Ordinary (taxable) dividends are the most common type of distribution from a corporation. According to the IRS, you can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation tells you otherwise. These dividends are taxed when paid by the ETF.

Qualified dividends are subject to the same maximum tax rate that applies to net capital gains. Your ETF provider should tell you whether the dividends that have been paid are ordinary or qualified. Exceptions - Currency, Futures and Metals As in just about everything, there are exceptions to the general tax rules for ETFs.

A good way to think about these exceptions is to know the tax rules for the sector. ETFs that fit into certain sectors follow the tax rules for the sector rather than the general tax rules. Currencies, futures and metals are the sectors that receive special tax treatment.

* Currency ETFs - Most currency ETFs are in the form of grantor trusts. This means the profit from the trust creates a tax liability for the ETF shareholder, which is taxed as ordinary income. They do not receive any special treatment, such as long-term capital gains, even if you hold the ETF for several years.

Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods. (To learn more about these funds, read Profit From Forex With Currency ETFs. ) * Futures ETFs - These funds trade commodities, stocks, Treasury bonds and currencies.

For example, PowerShares DB Agriculture (AMEX:DBA) invests in futures contracts of the agricultural commodities - corn, wheat, soybeans and sugar - not the underlying commodities. Gains and losses on the futures within the ETF are treated for tax purposes as 60% long-term and 40% short-term regardless of how long the contracts were held by the ETF. Further, ETFs that trade futures follow mark-to-market rules at year-end.

This means that unrealized gains at the end of the year are taxed as though they were sold. (To learn the basics, check out Modernize Your Portfolio With ETF Futures. ) * Metals ETFs - If you trade or invest in gold, silver or platinum bullion, the taxman considers it a "collectible" for tax purposes.

The same applies to ETFs that trade or hold gold, silver or platinum. As a collectible, if your gain is short-term, then it is taxed as ordinary income. If your gain is earned for more than one year, then you are taxed at either of two capital gains rates, depending on your tax bracket.

This means that you cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold, silver or platinum. Your ETF provider will inform you what is considered short-term and what is considered long-term gains or losses. (To learn more about the special tax issues of gold and other metals ETFs Tax Strategies Using ETFs ETFs lend themselves to effective tax-planning strategies, especially if you have a blend of stocks and ETFs in your portfolio.

One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way your gains receive long-term capital gains treatment, lowering your tax liability.

Of course, this applies for stocks as well as ETFs. In another situation, you might own an ETF in a sector you believe will perform well. However, the market has pulled all sectors down giving you a small loss.

You are reluctant to sell, since you believe the sector will rebound and you could miss the gain due to wash-sale rules. In this case, you can sell the current ETF and buy another that uses a similar but different index. This way you still have exposure to the favorable sector, but you can take the loss on the original ETF for tax purposes.

ETFs are a useful tool for year-end tax planning. For example, you own a collection of stocks in the materials and healthcare sectors that are at a loss. However, you believe that these sectors are poised to beat the market during the next year.

The strategy is to sell the stocks for a loss and then purchase sector ETFs such as the S&P Materials Select Sector SPDR (AMEX:XLB) and Health Care Select Sector SPDR (AMEX:XLV). This way you can take the capital loss without losing exposure to the sectors. The Bottom Line Investors who use ETFs in their portfolios can add to their returns if they understand the tax consequences of their ETFs.

Due to their unique characteristics, many ETFs offer investors opportunities to defer taxes until they are sold, similar to owning stocks. In addition, as you approach the one-year anniversary of your purchase of the fund, you should consider selling those with losses before their one-year anniversary to take advantage of the short-term capital loss. Similarly, you should consider holding those ETFs with gains past their one-year anniversary to take advantage of the lower long-term capital gains tax rates.

ETFs that invest in currencies, metals and futures do not follow the general tax rules. Rather, they follow the tax rules of the underlying asset, which usually results in short-term gain tax treatment. As a general rule, ETFs follow the tax rules of the underlying asset, which should help investors with their tax planning.

Calculating Taxes on Fund Sales FIGURING YOUR TAX BILL on mutual fund sales is about as fun as going over a waterfall in a canoe. But, if you plan ahead and maintain good records, you can save yourself a bundle come April 15. The most important thing to remember is that you must decide which tax calculation method you will use before you sell your shares.

Otherwise, you will be stuck using the FIFO (first-in, first-out) or average basis method, and those may not be the best for you. So, read on. Figuring the Tax Basis of Shares You Are Selling The tax gain or loss from mutual fund sales is calculated by comparing your tax basis in the shares sold to the sales proceeds net of any transaction costs.(For more on stock sales, see "Calculating Taxes on Stock Sales.

") In general, the tax-planning objective is to maximize the basis in the shares being sold to minimize the gain, or maximize the loss. You may also be selling losing fund investments with the objective of offsetting gains from earlier transactions.In fact, you can sell enough losers to completely offset those gains and generate a $3,000 net capital loss for the year ($1,500 for married taxpayers filing separately). You can then deduct that loss against your other income from all sources (wages, interest, etc. ).

Now, if you sell your entire holding in a particular fund, it's easy to determine your tax basis. It is the sum total of the cost of all your share acquisitions, including any that you bought via the fund's automatic dividend reinvestment program. However, things get tricky when you sell only a portion of your shares after having purchased them at different times and different prices.In this case, think of your investment as consisting of several blocks of shares purchased on various dates.

Usually, each block has a different per-share cost. Some blocks may have been held over 12 months and some less.So, when you sell some shares, you need a method to determine which block those shares came from. You can then calculate your gain or loss and determine whether it's classified as long term or short term.

The Tax Code allows four methods: * first-in, first-out (FIFO) method; * specific identification (specific ID) method; * single-category or "regular" average basis method; and * double-category average basis method. FIFO Method This method assumes that shares you sell come out of the earliest-acquired blocks you own. Example 1: Say you bought your first 100 shares in a particular fund for $20 per share (Block #1).

Later, you bought 100 more for $25 (Block #2). Still later you bought another 100 for $24 (Block #3). You then sold 150 shares for $26 ($3,900).

Under FIFO, you are assumed to have sold all of the shares in Block #1 (tax basis of $2,000) plus 50 shares from Block #2 (tax basis of $1,250). Your gain is $650 ($3,900 proceeds less basis of $3,250). To use FIFO, you must have a record of the per-share price and acquisition date for each block.

In a rising market, FIFO tends to generate the biggest tax bill, because the oldest, cheapest shares are considered sold first. However, FIFO also increases the odds that your gains will be long term and therefore qualify for the 20% maximum rate. As far as the IRS is concerned, FIFO is the "default" method.

In other words, you must use FIFO to calculate mutual fund gains and losses, unless you take the action required to use one of the alternative methods explained below. Specific ID Method Under this method, you specify exactly which block (or blocks) of mutual fund shares you intend to sell, so you can minimize gains or maximize losses by selling your highest-cost shares first. Example 2: Same facts as in Example 1 above.

Using specific ID, you can sell 100 shares from Block #2 (basis of $2,500) and 50 from Block #3 (basis of $1,200). So your gain is only $200 ($3,900 proceeds less basis of $3,700), vs. $650 if you used FIFO. To use specific ID, you must instruct your broker or the fund to sell specific shares by reference to their acquisition date and per-share cost.

In other words, you must take action at the time you make the transaction (otherwise, there's nothing you can do to make the specific ID method available next year, when you are slaving over this year's tax return). Also, the broker or fund must send you a written confirmation of your instructions. Keep this in your tax file to prove you followed the rules.

Unfortunately, some brokerage houses and fund companies don't issue conformations because of the paperwork involved.In this case, keep a written record of your oral instructions regarding which shares you've sold. One more thing: Remember that selling the most expensive shares could mean your gains will be short term and therefore taxed at your regular income tax rate rather than the long-term capital gains rate of 15%. However, if you are selling losers, it's generally better to sell short-term shares.

Your short-term losses will then offset short-term gains that would otherwise be taxed at your income tax rate. Single-Category Average Basis Method This method is available when you leave your mutual fund shares on deposit in an account with an agent or custodian, but not when you actually have possession of your share certificates. Each time you make a sale, you simply figure your average presale basis for shares of that fund.

For holding period purposes, you are considered to sell the oldest shares first. Example 3: Same facts as in Example 1. Immediately before the sale of 150 shares, your average basis was $23 per share (total cost of $6,900 divided by 300 shares).

So your tax gain this time is $450 ($3,900 proceeds less basis of $3,450). Almost all funds now report single-category average basis numbers on transaction statements. They may also automatically calculate your gains and losses under this method.

This is very convenient, but as Example 2 illustrates, it doesn't necessarily minimize your taxes. If you want to use the single-category average basis method, you must indicate so by making a notation on the line of Schedule D, where the gain or loss from the transaction shows up. Just write "single-category average basis method."

Beware. Once you use this method for a particular fund, you must continue to do so for all future sales of shares in that fund. (Other funds are unaffected.) Double-Category Average Basis Method Here you separate shares into two pools -- one consisting of all long-term shares (held over 12 months), and the other consisting of all short-term shares.

Then each time you sell, you calculate the average per-share basis for each pool. You can then sell strictly out of one pool or the other, or mix and match as you see fit. The advantage is you have more flexibility to control the basis of the shares being sold and whether the resulting gains will be taxed at 15% or your regular rate.

Example 4: Same facts as in Example 1. Assume the 100 shares you bought at $20 are in the long-term pool and the remaining 200 shares are in the short-term pool (average basis of $24.50). As before, you sell 150 shares for $3,900.

Using the double-category average basis method, you choose to sell all 150 shares out of the short-term pool. This results in a short-term capital gain of $225 ($3,900 of proceeds less basis of $3,675). Alternatively, you could decide to sell all 100 shares in the long-term pool and 50 shares out of the short-term pool.

This would result in a long-term gain of $600 ($2,600 proceeds less basis of $2,000) and a short-term gain of $75 ($1,300 proceeds less basis of $1,225). For my money, it makes more sense to use the specific ID method rather than the double-category method. With specific ID, you can tailor the tax results with greater exactitude for the same amount of trouble.

Also, once you use the double-category method for a particular fund, you are locked into it for all future sales of shares from that fund. In contrast, using specific ID has no impact on future transactions. But if you want to use the double-category method, you must specify to your broker or fund how many shares you want to sell out of each pool, and your instructions must be confirmed in writing (just like for specific ID).

If your fund won't give you a confirmation, you are considered to sell shares from the long-term pool first. Finally, you must write "double-category average basis method" on the line of Schedule D. Watch Out for 'Wash Sales' If you intend to sell some mutual fund losers for the tax savings, watch out for the dreaded "wash sale" rule.

Your tax loss gets disallowed if you buy back the same fund shares within 30 days. This is not a total disaster, because the disallowed loss gets added to the tax basis of the shares you buy back.So you'll eventually make up the difference with a smaller gain or bigger loss when you sell those shares. Still, your expected tax loss gets shelved.

You can avoid the problem by repurchasing shares in a different fund with the same investment characteristics. For instance, sell one small-cap fund, then buy a different small-cap fund run by a different manager. You might get in trouble, however, if you sell one S&P 500 index fund, then buy another one within 30 days.

Also, be sure to "turn off" your automatic dividend reinvestment program if it would cause a buyback within 30 days after your loss sale. The buyback would rule out some or all of your tax savings under the wash sale rule. 3)If you sell out of one fund at a loss of $10, then buy into another and gain $5, will the IRS tax you on the $5 gain, or recognize that you're down for the year?

You may also be selling losing fund investments with the objective of offsetting gains from earlier transactions.In fact, you can sell enough losers to completely offset those gains and generate a $3,000 net capital loss for the year ($1,500 for married taxpayers filing separately). You can then deduct that loss against your other income from all sources (wages, interest, etc. ).

Generally speaking there are a couple kinds of Capital Gains tax that you should be concerned with. 1. The kind of gain from your question sounds more like gains from the purchase and sale of securities.In this situation, you are only taxed at the time of sale.

If you sell one fund and have a net loss of $10, then you'd declare this as a loss and it would decrease your adjusted gross income (AGI) on your 1040. The length of time that you hold the security influences the amount of tax that you'll pay. Gains from sales of securities held less than 1 year are taxed as Short Term CGs, at a higher rate.

Your $5 gain isn't a gain until you actually realize it with a sale. 2. Short and Long Term CGs from mutual funds.

During the course of business, fund managers buy and sale actual stocks comprising the fund. This creates Gains for the fund, which are distributed to fund holders at the end of the year. These amounts are reported on an IRS form 1099-DIV.

These are divided into Short Term (higher tax rate) and Long Term (not as high tax rate). These amounts are reported on a Schedule D for your 1040. You may need to seek the advise of an Accounting Professional, and should definitely review IRS Pub 544.

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