Netting Short-Term and Long-Term Gains and Losses

We're into the final stretch of the Schedule D, the part where you actually compute your capital gains and losses.

In Part I of Schedule D, you'll net your short-term gains and losses from sales of investment assets, as well as any from bad debts, casualty losses, installment sales, and like-kind exchanges; and from partnerships, S corporations, or estates and trusts as reported on Schedule K-1. You'll also net any carryovers of short-term losses from previous years. By "netting" we mean that your total short-term losses are subtracted from your total short-term gains, and the result will be a net gain or loss.

Then, in Part II of Schedule D, you go through the same process with your long-term gains and losses. In Part II you are required to report separately (in Column (g)) any long-term gains or losses from art, jewelry, antiques, precious metals, etc., which are termed "collectibles," and up to 50 percent of the eligible gain on qualified small business stock, which are taxed at a 28 percent rate. The result will be a net long-term gain or loss.

Then, you take your short-term gain or loss and net it against your long-term gain or loss.

Gains. If the result is a gain, it must be reported on Line 13 of the 1040 Form. Then, go on to complete the rest of your 1040 Form. After you complete the rest of your income, adjustments, and deductions, and you're ready to figure out the actual amount of tax you owe, you must come back to Part III of the Schedule D to compute your taxes using the special lower rates for various types of capital gains.

Part III of Schedule D looks much more daunting than it actually is. You must follow the directions for each line, to the letter, but if you do that you'll effectively separate out any gains on collectibles and eligible small business stock, or on unrecaptured real estate depreciation, and tax them at 28 percent and 25 percent, respectively. The computations will also help you find out whether you're in the 10 or 15 percent bracket and, if so, tax your long-term capital gains at only five percent.

Did You Know? For sales made after May 5, 2003, Congress lowered the maximum dividend and capital gains tax rates for most (but not all) dividends and capital gains from 20 percent to 15 percent for qualifying taxpayers. Taxpayers in the 10- and 15-percent tax brackets are eligible for an even lower rate of five percent. In 2008, the rate for taxpayers in the 10- and 15-percent tax brackets falls to zero. As originally enacted, these tax rate cuts were temporary and were scheduled to expire at the end of 2008. However, the Tax Increase Prevention and Reconciliation Act of 2005 extends the cuts for two more years through December 31, 2010. However, the 28 percent rate imposed on long-term gain from collectibles and small business stock remains unchanged. Also unchanged are the $3,000 per year limit on net capital losses and the 12-month ownership requirement in order to be classified as a "long-term" asset.

A note on Line 19 asks for your unrecaptured section 1250 gain, if any. This refers to depreciation you claimed on business or investment real estate over the years. If you invested in any REITs or mutual funds that invest directly in real estate, the amounts you need will be shown in Box 2c of Form 1099-DIV. If you sold any business or commercial real estate last year, you'll need to see the directions for Schedule D in order to complete this item. If you didn't receive a copy with your IRS tax package and instructions, you can get a copy by calling 1-800-TAX-FORM.

Losses. If you subtract your losses from your gains and the net result is a loss, you can claim a capital loss on your tax return. Transfer the loss amount to Line 13 of your Form 1040, and enclose it in parentheses to indicate that it should be subtracted from your other income items.

If your capital loss for 2007 is more than $3,000 (more than $1,500 for marrieds filing separately), you may not be able to deduct the entire loss. In most cases any amount above $3,000 will have to be carried over to later years, and deducted at the rate of $3,000 per year until the entire loss is used up. When you carry over a loss, it retains its character as short-term or long-term. The worksheet included below will help you to calculate your carryover amounts.

Planning Tools You can use this capital loss carryover worksheet to figure out the amount of losses that you can carry over to later tax years. When you complete the worksheet, be sure to keep a copy in your records so that you remember to deduct the carryover loss next year, and so that you have proof of the amounts in case you are audited.