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Capital Gains & Losses (Part 2)

Introduction

Hey everyone!

This is the second post of a series of informative U.S. tax posts. The goal of these posts will be to provide awareness to the current state of U.S. tax regulation. We, the authors, will attempt to write the information in an easy-to-understand format. Keep in mind, this will not solely cover cryptocurrency taxation, but all U.S. tax regulation. This being said, the early focus of these posts will cover topics closely intertwined with cryptocurrency.

In any posts relating to cryptocurrency, we will explain the current treatment as per the Internal Revenue Code (IRC) as well as sometimes touching on the proposed treatment, suggested by the American Institute of Certified Public Accountants (AICPA).

It is our hope that these posts will spark productive conversation and lead to fairer tax legislation. Remember, debating is promoted, but please remain civil! As this post is a continuation of the previous post, if you haven't already, please check out Capital Gains & Losses (Part 1).

Throughout this series of posts, we hope to cover the following:

Key Vocabulary for Understanding Capital Gains/Losses - Previously Covered in Part 1
What are Capital Gains/Losses? - Previously Covered in Part 1
What is a Carryforward/Carryback?
What Events Initiate Gain/Loss Recognition?
What Inventory-Costing Methods are Allowed?

Key Vocabulary

While the Key Vocabulary was also present in Part 1, I feel it may prove beneficial to reiterate it here to refresh your memories. The vocabulary is as follows:

Cost Basis – The cost basis is used to establish gain and losses. The basis is the amount the property was acquired for or amount of the property previously taxed (i.e. I buy Bitcoin at $1 and sell it for $10, the $1 is my cost basis). Secondly, if Bitcoin is mined when it is worth $10, that $10 is considered ordinary income at the time the mining was completed requiring immediate tax recognition and, as a result, establishing a cost basis of $1).
Holding Period – This is the length of time property is held.
Long-Term Holding – This is defined by a holding time of greater than 1 year.
Short-Term Holding – This is defined by a holding period of 1 year or less.
Ordinary Income - Normal income from anything other than capital gains.
First-In-First-Out (FIFO) – An inventory identification method, it assumes that the first assets purchased are the first assets sold.
Last-In-Last-Out (LIFO) – An inventory identification method, it assumes that the last assets purchased are the first assets sold.
Specific Identification Method – An inventory identification method, it directly identifies the asset sold, there are no assumptions. This is generally what is used for high-value, large inventory (i.e. cars).

Capital Loss Carryforwards/Carrybacks

As previously mentioned, if a net loss occurs (total losses are greater than total gains) individuals are allowed to carry their loss forward indefinitely. This carried forward gain can be used to offset up to $3,000 of ordinary income per year (including the current year) and all future capital gains. Let’s go through another example:

Case Facts:

Every year, (Years 0, 1, 2, and 3) there is ordinary income of $100,000.
There is a total capital loss of $20,000 in the current year (Year 0).
Next year (Year 1) there is a total short-term capital gain of $5,000.
The following year (Year 2), there is no capital gains/losses.
The following year (Year 3), there is a total short-term capital gain of $15,000.

Case Questions & Answers:

In Year 0, what is the current year net capital gain/loss, net taxable income, and remaining amount of carryforward?
- Current Year Net Capital Loss = $20,000
  - (Total Capital Gains - Total Capital Losses)
  - ($0 - $20,000)
- Net Taxable Income = $97,000
  - (Ordinary Income + Current Year Capital Gains - [Current Year Net Capital Loss + Previous Year Loss Carryforward]^{Limited to $3,000 Excess of Current Year Capital Gain})
  - ($100,000 +$0 - $3,000^{$20,000 + $0 is Greater than $3,000 Excess of Current Year Capital Gain})
  - Explanation - In Year 0 there is $100,000 ordinary income and no capital gains. As such, the only income in Year 0 is the $100,000. With regard to expenses (or losses) there is a net capital loss of $20,000. Now, remember, you are not allowed to deduct more than $3,000 of capital losses from ordinary income each year. Since all income in Year 0 was ordinary income ($100,000) we are limited to deducting only $3,000 from the income, therefore a Net Taxable Income of $97,000 exists.
- Remaining Loss Carryforward = $17,000
  - (Previous Loss Carryforward + Current Year Net Capital Loss - Carryforward Utilized in Current Year)
  - ($0 + $20,000 - $3,000)
  - Explaination - As this is Year 0 no previous carryforwards exist. As a result, there is nothing to add to the loss pool other than the current year loss of $20,000. However, because we were able to offset $3,000 of ordinary income with the loss, we have a total $17,000 loss to carryforward.
In Year 1, what is the current year net capital gain/loss, net taxable income, and remaining amount of carryforward?
- Current Year Net Capital Gain = $5,000
  - (Total Capital Gains - Total Capital Losses)
  - ($5,000 - $0)
- Net Taxable Income = $97,000
  - (Ordinary Income + Current Year Capital Gains - [Current Year Net Capital Loss + Previous Year Loss Carryforward] ^{Limited to $3,000 Excess of Current Year Capital Gain})
  - ($100,000 + $5,000 - [$5,000 + $3,000]^{$17,000 + $0 is Greater than $3,000 Excess of Current Year Capital Gain})
  - Explanation - Just as in the previous year, the Year 1 ordinary income is $100,000. However, unlike the previous year, there is a current year net capital gain of $5,000, which is offset by the loss carried forward from Year 0. After using the $5,000 of loss, there is still $12,000 of the carryforward remaining, however, remember that we can't offset more than $3,000 of ordinary income with capital losses per year. Thus, we have a net taxable income of $97,000.
- Remaining Carryforward = $9,000
  - (Previous Loss Carryforward + Current Year Net Capital Loss - Carryforward Utilized in Current Year)
  - ($17,000 + $0 - $5,000 - $3,000)
  - Explanation - There was a previous loss carryforward from Year 0 of $17,000. Of this $17,000 $5,000 was used to offset the current year capital gain, then another $3,000 was used to offset ordinary income. As a result, there is a $9,000 carryforward.
In Year 2, what is the current year net capital gain/loss, net taxable income, and remaining amount of carryforward?
- Current Year Net Capital Gain/Loss = $0
  - (Total Capital Gains - Total Capital Losses)
  - ($0 - $0)
- Net Taxable Income = $97,000
  - (Ordinary Income + Current Year Capital Gains - [Current Year Net Capital Loss + Previous Year Loss Carryforward] ^{Limited to $3,000 Excess of Current Year Capital Gain})
  - ($100,000 + $0 - [$0 + $3,000 ^{$9,000 + $0 is Greater than $3,000 Excess of Current Year Capital Gain})
  - Explanation - There is only ordinary income of $100,000 in Year 2, with no capital gains or losses for the year. As such, we can only deduct up to $3,000 of the remaining loss carryforward. As a result, we are left with $97,000 net taxable income.
- Remaining Carryforward = $6,000
  - (Previous Loss Carryforward + Current Year Net Capital Loss - Carryforward Utilized in Current Year)
  - ($9,000 + $0 - $3,000)
  - Explanation - There was a loss carryforward from Year 1 of $9,000 and no current year losses to add to it. $3,000 of the carryforward was used to offset the ordinary income, thus leaving us with a remaining balance of $6,000.
In Year 3, what is the current year net capital gain/loss, net taxable income, and remaining amount of carryforward?
- Current Year Net Capital Gain = $15,000
  - (Total Capital Gains - Total Capital Losses)
  - ($15,000 - $0)
- Net Taxable Income = $109,000 ($100,000 + $15,000 - $6,000)
  - (Ordinary Income + Current Year Capital Gains - [Current Year Net Capital Loss + Previous Year Loss Carryforward] ^{Limited to $3,000 Excess of Current Year Capital Gain})
  - ($100,000 + $15,000 - [$0 + $6,000])
  - Explanation - There is two sources of income in Year 3 - $100,000 ordinary income and $15,000 net capital gains. However, the remaining $6,000 of the loss carryforward can be used to offset the capital gains, reducing the gains $9,000. As a result the net taxable income is $109,000.
- Remaining Carryforward = $0
  - (Previous Loss Carryforward + Current Year Net Capital Loss - Carryforward Utilized in Current Year)
  - ($6,000 + $0 - $6,000)
  - Explanation - There was a $6,000 loss carryforward available from Year 2 and no current year losses to add to it. All of the $6,000 was used in Year 3 to offset the capital gains in Year 3. As a result, the loss carryforward pool was completely depleted to $0.

Conclusion

This concludes Part 2 of the Capital Gains/Losses series. Hopefully this post was able to shed some light on the treatment of capital gain/loss treatment in the United States. Please don't hesitate to comment below with any questions or input that you may have and make sure to follow the @met account for Capital Gains & Losses (Part 3) and all other future business-related posts!

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About the Author

I hold a Master’s degree in Accounting with a concentration in Information Management. This degree has given me years of exposure to topics, as it relates to the USA, such as: financial reporting, financial statement audits, information systems audits, tax regulation, business law, and overall general business knowledge. Shortly after obtaining my degree I worked for a large public accounting firm for about a year, focusing on IT audits, only deciding to leave to put more focus on cryptocurrency.

While I am not technically a Certified Public Accountant (CPA), I have met the educational requirements and passed all four sections of the CPA on the first try; the only requirement left is to obtain the required experience hours, which I am extremely close to. All of this being said, I can safely say that I am well versed in business knowledge and am more than capable of learning business related concepts.

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Keeping You Safe from the IRS: U.S. Tax 101 (Blog #2) - Capital Gains & Losses (Part 2)