Tax Director and Construction Practice Member
There has been so much discussion in the media about capital gains lately, we thought it would be good to revisit some of the basic concepts. Congress is currently in the process of drafting proposals for changes to the tax code. The most recent proposal indicates there will be no changes to the current capital gains rates. In this article, we will discuss what a capital gain is and provide some examples that are typical for the construction industry. We will then discuss how capital gains are currently taxed and some opportunities for tax savings.
What is a capital gain?
A capital gain cannot occur unless you have a capital asset. A capital asset is any asset owned by your business that has a life longer than one year and is not being held for sale. You will typically classify these as Plant Property & Equipment on your business balance sheet.
A capital gain is realized when a capital asset is sold for more than its historical cost (less depreciation). For construction businesses, capital assets are usually significant pieces of property with a useful life longer than one year, such as equipment like excavators, backhoes, and trucks. This also makes them a type of production cost. Other examples of capital assets are investment properties and even the stock of a closely held business.
A capital asset is generally owned for its role in contributing to the construction business’s ability to generate profit. Furthermore, it is expected that the benefits gained from the asset will extend beyond a time span of one year.
Capital asset disposition happens by selling, trading, abandoning, or even losing them in foreclosures. Capital assets can also become damaged on the construction site. When one of these events occurs, the business must recognize the gain or loss from the event.
In many cases, if the business owned the asset for longer than a year, it incurs a long-term capital gain or loss on the sale. However, if the business deducted any depreciation expense while it held the capital asset, the depreciation amount is recaptured as ordinary income rather than capital gain income.
Capital gains can also play a role in succession planning if a construction business owner sells the stock in their company. This transaction occurs at the owner level, and additional planning can result in significant tax savings.
Capital gains tax rates and tax planning strategies
Previously, you faced three federal income tax rates on Long-Term capital gains—0%, 15%, and 20%—and they were tied to the ordinary income rate brackets. After 2018, these rates have their own brackets that are no longer tied to the ordinary-income brackets. Short-term capital gains are taxed at ordinary income tax rates as high as 37%. Certain higher-income taxpayers are also subject to the additional 3.8% net investment income tax.
Capital losses are generally deductible in full against capital gains, and any capital losses in excess of capital gains may offset up to $3,000 of ordinary income ($1,500 if you are married filing separately). If you have incurred capital losses in your construction business or with other assets in 2021, it may be a good time to consider selling any capital assets that have gain in them. But be sure to weigh all relevant factors before you make any investment decisions. In certain circumstances, taxpayers may want to consider the rule that when the taxpayer passes away, assets usually take on a basis equal to fair market value, so the heir may have little or no gain for tax purposes. We should also note that businesses that are operated as Corporations do not recognize any tax rate difference for capital gains or losses.
Another consideration with capital assets in the area of stock investments is wash sales. Exercise caution before selling securities to realize a tax loss with the thought of buying back in shortly afterward. Under the tax law’s “wash-sale” rules, no capital loss deduction is allowed in the year of the sale if you buy substantially identical securities within 30 days after (or before) the sale. Instead, the disallowed loss becomes part of your cost basis in the newly acquired securities. This delays the tax benefit from the capital loss until you sell the replacement securities.
We hope this recap of capital assets is helpful to you. Our Construction Group will continue to monitor the developments in Washington and keep you posted on the proceedings on what is sure to be an interesting couple of weeks. If you have any questions, please reach out to your trusted advisor at Suttle & Stalnaker.