Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the

Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the

value of an asset. however, in tax law a capital gain is specifically a real- ized gain that results when an asset is sold for more than was paid for it. Because tax rates are progressive, taxing capital gains in one lump in one year at higher rates seems unfair, so Congress has traditionally granted special treatment—via lower effective tax rates—to capital gains.

Special treatment for capital gains has come in either of two ways: (1) an exclusion of a portion of the gain or (2) a cap on the tax rate applied to capital gains. A cap is a “ceiling” on the tax rate applied to capital gains and is lower than the tax rate applied to other income. In 2001, for example, the tax rate cap on capital gains was 35% for corporations.

Taxation

Suppose that in 2001 the Taxit Corporation has ordinary taxable income (that is, taxable income not including capital gains) of $50,000 and a capital gain of $10,000. Taxit’s tax bracket is 25%, which is below 2001’s corporate capital gains rate of 35%. So Taxit’s tax on its $60,000 of income is:

Tax on $60,000 = $7,500 + 0.25($60,000 − $50,000) = $10,000 Suppose instead that Taxit has ordinary income of $200,000 and a

capital gain of $10,000. Taxit’s tax is:

Tax = $22,250 + 0.39 ($200,000 − 100,000) + 0.35 ($10,000)

↑ tax on ordinary income

tax on capital gain income = $61,250

The other way of giving special treatment to capital gains for tax purposes is the exclusion. A capital gains exclusion excludes a portion, say 60%, of the capital gain from taxation and taxes the remainder at the ordinary tax rate. Consider Taxit Corporation’s income. If 60% of its capital gain is excluded, only 60% of the $10,000, or $6,000 is included in taxable income.

After a while, Congress caught on that for a depreciable asset, a part of the gain was really the result of “over-depreciating” it (for tax purposes) during its life; that is, depreciation expenses taken over the life of the asset (which reduced taxable income and taxes) do not repre- sent the actual amount the asset depreciated in value. So, Congress inserted provisions in the tax laws that require breaking the gain into two parts:

1. The recapture of depreciation, the difference between (a) the lower of the original cost or the sales price and ( b) the under-depreciated por- tion of the asset’s cost for tax purposes.

2. The capital gain, which is the sales price less the original cost. The recapture portion of the gain is taxed at ordinary rates, and the

capital gain portion is given special treatment (so effectively, it is taxed at less than ordinary rates).

Suppose Reclaim Inc. bought a depreciable asset ten years ago for $100,000, and its book value (cost less accumulated depreciation) for tax purposes is now $30,000. This means that the firm has taken $70,000 of depreciation expense over the ten years and has reduced its

FOUNDATIONS

taxable income by that amount. If it now sells this asset for $125,000, it has a capital gain of $25,000:

Sales price

Capital gain

But Reclaim has also recaptured its entire depreciation expense by selling the asset. The tax code requires that recaptured depreciation be added to ordinary income and, thus, taxed at the ordinary income tax rate. Reclaim would have to pay ordinary income tax on the recaptured $70,000 of depreciation and capital gains tax on $25,000.

Original cost $100,000 Less book value

30,000 Recapture (taxed as ordinary income)

$70,000 If only part of the asset’s depreciation is recaptured when it is sold,

only the recaptured part is taxed, and there would be no capital gain. The recaptured portion is the difference between sales price and book value. For example, if Reclaim sold the asset for $75,000, instead of $125,000, it would have:

Sales price $75,000 Less book value

30,000 Recapture (taxed as ordinary income) $45,000

As you can see, taxes, depreciation, and capital gains are all mutu- ally related. Furthermore, they all become considerations in investment decisions, which almost always deal in some way with the purchase and sale of assets, and in cash flow, which is directly affected by tax law.