Understanding Capital Gains

It’s the end of the year and a new one’s just begun. We’re all interested in seeing the hope and opportunity for the year to come; we all want to make the most of the time we have. We need to be happy, we need to be healthy, and we need to make money. But what about last year; what about what was? We hear all manner of financial folks and talking heads yammering on and on about capital gains taxes, how to shelter tax deferred income, appreciation, deprecation, and so on. “That’s not anything I need to know about; I’m not one of those hot-shot Wall Street guys. I only have some mutual funds.” But what are capital gains? Who has to worry about capital gains? How can capital gains affect your situation? Where should you go to lean more? All interesting questions; with answers that may surprise you.

First of all we should be sure we’re talking about the same thing. From Investorpedia.com a “capital gain” is described as “an increase in value of a capital asset that gives it a higher worth than the purchase price.” What is a capital asset? All sorts of things: real estate, stocks, stamps, fine art, rare rugs, antiques, coins, precious metals, and other items you may have if you’re doing business out of your home; computers, desks, chairs, and copiers are just a few of the myriad of items which can be considered capital assets. While most of your business merchandise will depreciate in value, with other things that’s not always the case. If you snapped a Polaroid with Michael Jackson and got him to sign it in 2009, for example, that may be worth considerably more posthumously.

Capital gains are not realized until the asset is sold. If you have that Polaroid and you keep it until the signature has faded, the image has worn away, and you wait until a point in the future when the commodity is no longer particularly valuable, you will have waited too long. Just like stocks, the value of your asset is only relative to your capital gains until the time that it’s sold. It’s impossible to know if you’ve sold at the high point without the benefit of hindsight, so don’t break your neck about it.

Capital gains exist with stocks and mutual funds. If you are a mutual fund investor you should be aware of when your mutual fund distributes “capital gains.” When you’re investing in a mutual fund, you’re investing in a bundle of stocks and commodities. Depending on the type of fund you’re invested in, this will determine the mix of your fund. Typically towards the end of the year a mutual fund will sell off some profitable investments which will potentially drive down the share price of the mutual fund, but will also afford investors “capital gains.” These gains can be found on Form 1099-DIV; investors in mutual funds should be aware of this as capital gains are taxed at long term capital gains tax rates regardless of how long you’ve personally held shares of the fund.

Capital gains can become something of a nuisance for the inexperienced investor (granted, capital gains are preferable to capital losses) so if your situation is unclear it’s a good idea and well worth your time to sit down and talk with a tax professional. Getting hip to your capital gains situation can help you from having to pay the piper well on down the road.

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