The Internal Revenue Service requires you to report the gains and losses incurred each year from selling your capital assets. And although it is part of the income tax, the IRS uses different tax rates for some of the net capital gains calculated on your return. However, you can always minimize your tax bill by offsetting your short-term capital gains with long-term losses.
Capital Asset Rules
The tax law defines capital assets as all property you own that is not used in a business. The rules classify your property as either investment or personal and as short or long-term. However, all capital gains and losses can offset each other to reduce your tax liability, regardless of each transaction's classification. Common types of personal property include your home, car and household items. Investment properties on the other hand cover items you purchase or construct with a motivation to earn income or recognize gain through appreciation in value. These typically include the financial investments you hold, such as stocks and bonds, and real property that you rent to tenants.
Asset Holding Period
You must evaluate the holding period for each asset you sell to properly classify it as short or long-term. This classification relates solely to the length of time that you own the property before selling it. Every capital asset you own for more than one year will result in a long-term gain or loss when you sell it. All other holding periods of one year or less will result in short-term gains and losses. The significance of this classification is that all net short-term gains are subject to the same tax rates as your other ordinary income such as wages and interest. However, your long-term gains receive special treatment by the IRS since the tax rates are significantly lower than ordinary rates, but can still vary depending on your level of income.
When you report your capital asset transactions on a Schedule D attachment to your return, the IRS requires you to separately net your short-term and long-term transactions to arrive at a net gain or loss for each category. If your short-term transactions result in an overall loss, you can use it to offset your long-term gains. However, if the long-term transactions also result in an overall loss, you can deduct up to $3,000 of it from your ordinary income each tax year. Your short-term losses are subject to the same deduction limitations; however, you can never deduct the short-term losses that result from the sale of personal property.
If the result of all short-term transactions is a net gain, you can use the long-term losses you incur to offset it and reduce your tax liability. However, if your long-term transactions also result in a net gain, the only way to avoid paying ordinary income tax rates on the short-term gains is by offsetting it with remaining capital losses from prior years.