Quimbee logo
DMCA.com Protection Status

U.S. Taxation of Capital Gains

4.9 out of 5 Excellent(17 reviews)
Start your FREE 7-day trial
Preview this course and the rest of Quimbee's CLE library for free with a 7-day free trial membership.
Buy this course - $49
Get access to just this course for $49
Play video

U.S. Taxation of Capital Gains

This course will provide a basic introduction to U.S.capital gains taxation rules,such as the calculation and determination of basis, adjustments to basis, and gain or loss in the disposition of capital and noncapital assets.Itwill also interweave advanced U.S.capital gains taxation rules such as depreciation recapture, sale of foreign real property, sale of cryptocurrency assets, and other non-resident alien taxation for the sale of U.S.real property.Lastly, this course will highlight the primaryreporting forms and conjunctive tie-in forms needed to ensure a complete and accurate tax return filing forcapital gains transactions.


Mishkin Santa
Principal, Director of International Tax
The Wolf Group


Mishkin Santa - Hi, everybody, my name is Mishkin Santa, and today I'll be presenting on U.S taxation of capital gains. When we look at capital gains tax, one of the first things that I like to point out to people are the changes in the capital gains tax since the inception of the U.S tax code.

As we can see here on this first slide, the first capital gains tax rate was the same as the regular income tax rate. And then slowly adjusts upwards from 12.5% to a maximum rate of 35% in 1979. After 1979, though, the capital gains tax rate fluctuates between 28 and 20%. And we land here today at a maximum capital gains tax rate for long term gains at 20%. The next thing to discuss is cost basis. Anytime we try to figure out a capital gain, we always need to start with the cost basis of the asset that we're talking about. Cost basis can be found in internal revenue code 1,012 and also in publication 551 and IRS topic 703. But generally speaking, the cost basis is the amount paid for what you're getting or the exchange of property for what you're getting. You can also adjust the cost basis by any costs for taxes, fees and commissions.

This is critically important, especially for new age transactions like cryptocurrency, where individuals may be paying commission or what we call gas fees for transactions. Typically the crypto-tax softwares don't pick these up. And so these are adjustments to basis that should be made by the accountant or by the taxpayer before reporting the basis on their tax return. The cost basis of real property is the, what you paid for, the real property when you purchased it or what you exchanged for the real property when you received it. If real estate taxes are paid to a seller, then these are included in the basis of the real property. You would also need to include any settlement costs, including transfer taxes and commissions from a real estate agent. When looking at the cost basis of real property, our firm typically will ask for the closing statement, which used to be called the HUD-1.

There's no real reporting when someone purchases a property, but it's always a good idea to review the HUD-1 and to make sure that the basis and adjustments to basis are documented for future purposes, should that taxpayer want to sell the property at a later date, that documentation will save them the headache of going back and trying to figure that out. You also need to make sure that when you're parsing the various transactions in the HUD-1, that you're not including insurance fees, loan fees, or other miscellaneous fees that may be lumped together. It's really important to get a breakdown of the HUD-1 from the closing agent or title company. Allocation of basis. This is very specific when you're doing say the sale of a business, you need to allocate the basis to various assets. And so, for example, if we were going to say, purchase a wide variety of assets for a lump sum, we'd want to go asset by asset and make sure that we're allocating the basis correctly. This is normally done by the buyer and seller when you're doing the sales contract. And a lot of times it's a big faux paw to come in after the sales contract is done and try to have someone figure out what the assets are and what the basis is for each asset. Again, this is something that should be agreed upon by the buyer and seller before the purchase is even done. And so when you're allocating basis, there's an order in which to do it for the assets and on the slide that is before you showing allocation of basis, you'll want to follow these rules when you're allocating.

So the first thing is you're gonna wanna look at certificates of deposit, U.S government securities, personal property, including stock securities, and cryptocurrency. That's the first item that you're gonna want to allocate basis to. The second would be accounts receivable. The third would be property of kind like inventory. The fourth would be intangibles like goodwill. That's always a thing that has to be determined at the point of sale. Section 197 intangibles would be next, and then goodwill, that doesn't qualify under 197. The disclosure of basis is normally done on IRS form 8594. This is a form that's not commonly filed, but should be done to make sure to document the basis with the Internal Revenue Service. From there, you can then make adjustments to basis once you've acquired the asset. There are certain things that will increase the basis of an asset or decrease the basis of an asset.

So for example, if I've purchased real property and I have to get it zoned, that cost of zoning the property will increase my basis. However, if I have to take a credit, let's say a residential energy credit that may decrease my basis in the asset. So again, it's important to walk through real life activities that are done and make sure that you're adjusting basis as you go. Inherited property is the next topic. So when one inherits property, they have to understand that there's what we call a step up in basis, which means that when someone passes away, whatever the value of the property was at the date of death is the value of the property that the person that inherits the property takes. That's called the step up in basis. In some cases, it's wise to get an appraised value as of the date of death, especially if it's a very large asset, it may be something to have on hand to prove to the IRS, should the asset ever be sold, what the step up value was at the date of death. We'll note that in some cases, when there is a closely held business, there's a special way to do the step up and basis rules and a special way to value the property. And typically you're gonna wanna look at the community property laws, if it's a community property state like Louisiana or Texas, but then you're also gonna wanna look at the special use valuation methods in the internal revenue code. And that will be internal revenue code 1014, and treasury reg 1014-1.

I'll note that when an individual U.S taxpayer inherits something from a non-resident alien, the step up and basis rules will also apply to that transaction. It should be noted though, that if the value of the property inherited exceeds $100,000, then that taxpayer, the U.S taxpayer, will have to file IRS form 3520 part four. That's a pretty critical filing because failure to file that form can trigger a $10,000 penalty. That form is a separate filing that is sent to the Ogden Utah Unit and is due by April 15th, and it can only be paper filed, it cannot be electronically filed. So keep that in mind, when you're asking about who did you inherit the property from and what was their status? Were they a tax resident or were they a non-resident alien? Okay, for the alternative valuation method, you're going to wanna fill out IRS form 706, that's the estate tax return. And normally this is done six months after the date of death. The rules that apply to the estate tax form can be found in internal revenue code 2032. The election for the alternate valuation method can be found on page one of the 706 part three. For those folks that are gonna help their clients report in estate tax return, it's very important that you understand how the form works and what assets need to be reported on that form. Calculation of gain or loss sale or exchange. So this is where the rubber meets the road. You've got your cost basis, you've got your adjustments to basis, now you have a taxpayer that's going to be selling their property, whether it's personal or real, and they're going to be recognizing a gain or loss. This is commonly seen with U.S stock, but it's more frequently seen these days with cryptocurrency transactions. And we'll talk a little bit more about cryptocurrency a little bit later.

However, the steps to calculate gain or loss are fairly straightforward and it's found on internal revenue code 1001, and then to determine short term or long term, you would go to internal revenue code 1222. You're gonna report the capital gain on IRS schedule D in the various forms 8949. There are several versions of the 8949, depending on whether cost basis was reported to the IRS or not. So make sure that you're picking the right form otherwise you could have a processing error when you submit your capital gains transactions. The steps to determine the capital gain are basically, again, you're gonna start with your basis, you're then gonna determine your adjustments to basis, and then your amount realized. The amount realized can be cash or money that's been received. It can be the fair market value of property received or services that have been provided. And it also assumes various liabilities. In some cases, when you have a partial disposition of an asset, you will then need to make sure that you look at the depreciation methods. This typically is falling under what we call the MACRS methods, and you can see this in treasure reg 1.168. Generally partial dispositions are gonna be reported on IRS form 4797, and the depreciation form 4562. When there's an abandonment, foreclosure or repossession, there are various rules and forms that are triggered. Generally speaking, an abandonment is not a sale of exchange, but can trigger a deductible loss.

Cancellation of debt can also occur. The cancellation of debt form that you'd have to complete is the 982, which is a very, very specific form. Foreclosure or repossession is generally a gain or loss and cancellation of debt can also occur in that situation. So it's important to understand, do I have an abandonment, foreclosure or repossession? If it's an abandonment, it's typically not a sale or exchange, so no gain, but there could be cancellation of debt, COD income. If it's a foreclosure or repossession, there could be a gain or loss, typically a loss, but there could also be cancellation of debt income. Non-taxable exchanges. This is generally the goal of a lot of transactions that occur when there is a liquidation or sale of a business or some kind of reorganization. The main key is to try to get a non-taxable exchange in hand, that way no one realizes any gain or loss. The gain or loss is in essence deferred to a later date. This is typically done on a like kind exchange, a partnership interest exchange, a treasury note or bond exchange, or some type of insurance or annuity exchange under internal revenue code 1035.

Like kind exchanges. Like kind exchanges were changed under the Tax Cuts and Jobs Act of 2017. Before 2017, you could do like kind exchanges of real property and personal property. However, because cryptocurrency is classified as personal property, Congress wanted to make sure that like kind exchanges were not being performed on the exchanges of cryptocurrency. Therefore, this was eliminated in the Tax Cuts and Jobs Act. Now, like kind exchanges can only be done with real property. And that's under internal revenue code 1031 in form 8824. To do a like kind exchange, there are two qualifications. First, the property must be a qualified property and it must be of like kind. I can tell you that this is a very specific area and you'll need to bring in an expert to help you conduct the analysis, to determine if it's a qualifying property and it's a like kind property. And so, for example, in some cases, someone may come to you and say, "Hey, I've got real property in the U.S, and I want to do a like kind exchange with foreign real property, that is not allowed.

So there are rules against what can and cannot be done. And again, my advice to anyone doing a like kind exchange is to find a qualified intermediary that works at a very specialized firm to help you do this. sale of qualified small business stock, which is internal revenue code 1202. This provision has been used very significantly over the last couple years. This is primarily done in startup companies that get very big very quickly, and they normally give the small business stock to their employees and their employees can then exclude up to $10 million or 10 times the basis in the qualified small business stock from taxation. The Build Back Better Act, which was not passed, wanted to reduce the exclusion to 50% of adjusted gross income in excess of $400,000. So there are some changes that could be on the forefront for 1202 stock, but until that occurs, this is a very powerful provision for small companies that want to issue stock. You can see the rulings on this in the ONTC memo, 2012-21, and the private letter ruling 20215004.

Deferral of gain for an investment in a qualified opportunity fund. When the qualified opportunity fund and opportunity zones were introduced under the Tax Cuts and Jobs Act, a lot of people were interested in getting the deferral of taxation under the qualified opportunity zone. This was a second way to potentially defer taxation for the sale of personal property. That like kind exchanges were the first way, but that was eliminated under the Tax Cuts and Jobs Act. So now, for example, if you have the sale of stock and you realize a large gain, or the sale of cryptocurrency, and you realize a large gain, you could potentially defer that gain under the qualified opportunity zone and qualified opportunity fund rules. The election has to be done within 180 days, or excuse me, the investment must occur within 180 days of realizing the gain. The actual election is then done on the tax return, schedule D, form 8949 in following year. Form 8997 may also be required to be filed. And I can tell you that as time moves forward, there's less and less benefit to doing the qualified opportunity fund and qualified opportunity zone investments because of the limitation that you can get for the return on invest. You still may be able to defer a large amount of the gain from tax, but the rules are limited as far as the timeline goes.

So it's important to look at the FAQs and understand if a client were to come to you or a taxpayer were to come to you for advice, exactly how the qualified opportunity zone investment would work out for their facts and circumstances. Capital assets versus non-capital assets. So typically capital assets are going to be different types of personal property, stocks, bonds, cryptocurrency, could also be real property like a home, a household furnishings, a car, coins, stamp, baseball cards, things like that. Non-capital assets are typically going to be found in inventory, accounts receivable or different types of intangible property like patents and copyrights. Other capital gains tax rates. Short term gain versus short term loss. So if you hold an asset or property for one year or less, your capital gain or loss is short term. Ordinary income tax rules will apply, you'll report the short term gain or loss on schedule D, form 8949. And again, that will be treated as an ordinary income or ordinary loss. To understand the rules of short term gain or loss, see internal revenue code 1222. Long term gain or loss is treated quite differently under preferential rates. So if you hold the asset or property for more than one year before you dispose of it, you get a long term capital gain or loss, which means that capital gains tax rates apply on a progressive rate system.

The rates are 0% for a certain amount of capital gain, 15% for the next tranche, and 20% for the highest tranche. I will note that in addition to these rates, the net investment income tax may also apply. So we could see in some cases, 18.8% or 23.8%. Again, there's a factoring of the total amount of income to determine if the net investment income tax would apply. I'll also note that in a situation where you have a foreign capital gain, and there are foreign tax credits that are being taken, foreign tax credits cannot be used to offset the net investment income tax, nor can the tax treaties. You cannot eliminate the net investment income tax under the tax treaty. Therefore, in some cases where you have a foreign capital gain with foreign tax credits that are being applied, the individual may still wind up owing 3.8% on the transaction.

There are other capital gains tax rates that you need to keep in mind. So for example, we talked earlier about the sale of qualified small business stock that's taxed at 28%. The sale of collectible assets, so for example, if you sold that Tom Brady rookie card, or that Derek Jeter rookie card, or in the new age, the non-fungible token or NFT, those are gonna fall under the collectible rules of 408M. You're gonna pay a tax of 28% on that sale. And then lastly, when you're selling a rental property, so real property that has been converted to a rental, there's a depreciation recapture, and that rate is a special rate of 25%. And you can find that under internal revenue code 1250.

Speaking of sale of business property, there are different rules that apply. Generally these rules are gonna fall under internal revenue code sections, 1231, 1245 and 1250. If you look closely on the form 4797, it's broken out into these various sections so that the reporting can be crystal clear as to what section you're reporting the sale of business property under. For 1231 business property, the sale of exchange must be done with real property or depreciable personal property, and must be used in a trader business for longer than one year. If you have a 1231 loss, it will be treated as an ordinary loss. However, if you have a 1231 gain, it'll be treated as an ordinary gain up to non-recaptured 1231 losses from prior years. Capital gains at long term rates will apply beyond these amounts. So there's a very different calculation when you're doing 1231, it's not as straightforward as normal capital gains tax rules for long term transactions. For the sale of 1245 property that typically occurs when you have a disposition of depreciable property. And examples of this would be personal property, tangible property, and then real property with certain types of adjusted basis. Lastly, you have 1250 property. 1250 property is also on certain types of depreciable property, but it also includes real property that is subject to an allowance for depreciation that is not and never has been 1245 property. So basically when you're going through these rules, you need to take the property that you're selling, the business property, and you need to classify it, is this 1231 property? Is it 1245 property? Or is it 1250 property?

Based on your classification, you can then determine the tax treatment that would apply on the sale of that property. FIRPTA. FIRPTA generally kicks in when you have a non-resident alien that is selling real property. The FIRPTA rules are gonna be found in internal revenue code 1445 and 1446. And generally what happens is when you have a non-U.S person that sells U.S real property, if the sales price is greater than a million dollars, closing agent will withhold 15% of that sales price. If it's less than a million dollars, then the withholding tax is 10%. And if it's under 300,000, then the withholding tax is zero. In order to get these rates, though, the buyer has to be an individual not a business, and they have to sign a document indicating that they plan to live in the property 50% of the time, as their primary residents for the next two years. If that is done, then you can get lower withholding tax rates. If it's not, then the general rule is that 15% withholding tax applies across the board. When withholding tax is remitted to the IRS in these in these situations, it's done under forms 8288 and 8288A.

The title company will complete these forms, they will include the seller's name, their social security number or individual tax identification number, the sales price, the amount of the withholding tax, a description of the real property sold and the fording address of the seller. This is very important because what happens is the IRS will take the withholding tax check, the form 8288A, and they will apply the money to the taxpayer's individual master file. Should the non-resident be able to get a refund based on their facts and circumstances, perhaps they didn't owe any tax on the transaction. Then the only way to get the money back would be to get the stamped copy of the 8288A back from the IRS, which is sent to the forwarding address. That stamped copy has a red stamp with a number at the top, and that's how the IRS knows that the withholding tax has been properly applied to the individual master file. In some cases, if the seller of the property knows that they're gonna pay a reduced withholding or that they know that the capital gain is not going to match the withholding tax, they can, before the property closes on sale, submit IRS form 8288B.

This form basically shows the math on the capital gain as applied to the sale transaction. And if that amount is less than the proposed withholding amount and the IRS can substantiate that amount, then they'll send a letter to the closing agent telling the closing agent to remit the withholding tax back to the taxpayer, the seller. In the meantime, the withholding agent will put the money aside in escrow and will not remit it to the IRS, as long as form 8288B is properly completed and sent down before the sale occurs. Internal revenue code 121. This is a very special internal revenue code, and it says, that if you've lived in U.S real property for two out of the last five years, then you may be able to exclude up to $250,000 of gain, if you're a single individual or if you and your spouse lived in the property together for two outta the last five years, $500,000 of gain. Typically non-residents don't live in United States, that's why they're non-residents.

However, there are some folks that are classified as non-residents, we call them tax exempt individuals that live inside the United States. These are typically diplomats under the A1 or diplomatic workers under the A2, international organization employees under the G1 or G4, or still students coming in under the F1J1 or M1 visas. So it's important to understand who you're working with, what type of visa they had and whether they lived in the property for two out of the last five years, so that you can properly apply the 121 exclusion. I talked earlier about the form, 8288B, and kind of how that works, but I wanna make sure to go over the fact that this is typically the driver, the 121 exclusion is typically the driver of the 8288B. And this normally occurs again, when you have someone on a tax exempt visa, that's been living in the property for two out of the last five years. They can then take the 121 exclusion and show that to the IRS on the form 8288B.

However, the form can be complicated if, for example, that individual was on assignment outside of the United States, rented the property out, so you have a property that's been converted to a business asset, and then came back to the United States to live in the property as their primary residence before they sold it. In that case, you would then have to make sure that all of the non-resident rental returns are filed. So again, non-resident aliens would be taxable on U.S rental income. That's what we call a non-effectively connected income. So it's tax blood at a flat rate of 30% on the gross rental. There can be an election called the net election on the rental, which allows the non-resident to take expenses against income. If that election was done, then depreciation will be taken. And depreciation recapture will have to be calculated when you're doing the form 8288B. Claim of refund. So this is another way when you're dealing with FIRPTA, that you can help your client get back funds. So, for example, if you sent in the form 8288B, perhaps it was denied or partially denied, you get another bite at the apple, which is the claim of refund. You can ask for the IRS to reconsider the substantiating documents you sent down by filing the form 843 and the denial letter for the 8288B.

Sometimes folks will want to do this, especially if they've sold property early on in a calendar year, because otherwise, they would have to wait until the next calendar year to file a non-resident return, request the refund through the non-resident return, which that process can take from the data filing in additional eight to 10 months before the IRS would remit the funds back to the taxpayer. So, the claim of refund can be a very, very powerful form to help the client perhaps get back their money long before they have to file that non-resident alien tax return. The form 1040NR. So I talked earlier about this. You have a non-resident alien that sold U.S real property. They are required, even if the withholding tax was returned to them, they are still required to file the non-resident return. In fact, if you look at an 8288B response letter, it clearly states you are still required to file the 1040NR in the next filing season. So when you do file that 1040NR, whether or not the withholding tax has been remitted to the IRS, you need to make sure that you get all of your ducks in a row. If there is an 8288A, make sure you get that stamped copy, and that's included with the filing, and then make sure that if you've been renting out the property that you have all the prior year returns in as well, because those are areas that can be ripe for audit, if you are reporting again, depreciation recapture and things like that. Okay, let's move on. Reporting domestic capital gains and losses.

So if I were gonna sell, say a stock or a bond here in the U.S, I'm gonna wanna report that capital gain or loss on schedule D page one, part one, if it's a short term gain or loss. If it's a long term gain or loss, I'm gonna go down one section to part two on page one of schedule D, and if it's a carryover loss, you'll see that online 14 on page one part two. Capital losses are limited to $3,000 if you're married, filing joint or $1,500, if single or married, filing separate. When you're reporting foreign capital gains or losses, there can be different treatment on this from a U.S income tax perspective. It's very, very important that you understand what type of capital gain or loss that you're dealing with. And in some cases, the passive foreign investment company rules, which can be found under internal revenue code 1291 and 1298 can kick in. And when these rules kick in, they're quite complicated. And so you may need to file a wide variety of forms, including form 8621, form 8938, or other types of forms. The form 8938 is the specified form, financial asset form. And failure to file that form could trigger a $10,000 penalty.

The form 8621, which is generally where PFICs are reported or Passive Foreign Investment Company stock, is done on a stock by stock basis. So for example, if I had a foreign brokerage account and I've identified that that account has 10 separate investments that are qualified as PFICs under 1291 through 1298, then each PFIC would have to be reported on a separate form 8621, and then I would need to identify the method in which I'm reporting that PFIC. There are basically three types of tax methods for PFICs. The first is called the excess distribution method under internal revenue code 1291. This is the worst of all worlds. In fact, it is the most complex and burdensome tax that we have in the U.S tax code. And if you have a taxpayer that is falling under the 1291 rules, I would tell them to divest of the PFIC as soon as possible. 1295 is the qualifying electing fund. This is the best of all worlds. There are some limitations to what the QEF election can allow the taxpayer to do, but generally you get to recognize capital gain and other types of income at normal rates. Lastly, we've got the 1296 rules, which are the mark-to-market rules, and when you think of mark-to-market, it's exactly what it sounds like. You take the value at the beginning of the year, you take the value at the end of the year, if it's a positive number, then it's gonna come out as ordinary income, if it's a negative number, then there's a certain special type of treatment that has to be documented, and we call that an inclusion.

Okay, so what is a PFIC? The PFIC rules came into being back in 1986 and had been changed over the years. That basically they're the product of lobbying by the Mutual Fund Industry in the United States in Wall Street. And basically what we have here is we have individuals that are utilizing foreign investments that basically are not being taxed on an annual basis. A lot of foreign investments what happens is that any dividends or gains are reinvested in the actual investment, and there's no annual taxation of those gains in the foreign country. In fact, there's no taxation until there's a divestment of the asset by the taxpayer. This is pretty much against what the internal revenue code wants to see happen. They want you to be taxed on an annual basis on the dividends, on the capital gains, on any distributions. And so, when you have a Passive Foreign Investment Company holding it's at odds typically with how the U.S capital gains tax rules work. And this is why we have the PFICs rules.

The PFICs rules guard against those types of assets. So, anytime you see a taxpayer that has foreign mutual funds or passive foreign investment stocks, those are things that could be PFICs. Those assets can be typically bought on the New York stock exchange as ADRs. There's no reason for a U.S taxpayer to have that through a foreign broker or foreign brokerage account. There are some foreign brokers though that do understand the PFIC rules and do strive to make sure that if they have U.S taxpayers, they're put into non-PFICs. So I wouldn't say that all foreign brokers or brokerage accounts are bad, but you do wanna make sure to quiz those foreign brokers on their knowledge of the PFIC rules and make sure they understand for the taxpayer, what is or is not a PFIC. I can also tell you that the tax accounting is super complex and very, very time consuming. And typically the tax bill alone can wipe out the return on investment, not to mention the punitive income tax rules that can be applied as well.

So, some examples of PFICs for foreign purposes are gonna pooled investments, mutual funds, exchange, traded funds, closed end funds, foreign hedge funds, foreign, what we call insurance rappers. And just so you understand what a foreign insurance rapper is, it's typically a product that's sold as an insurance product, but if you look at the driver of the return on investment, it's going to be some kind of pooled investment or foreign mutual fund. And it's specifically identified, if you look at the statements, it'll really tell you kind of what it's invested in. And that's how you know that it's an insurance rapper. It's just an insurance product that's actually wrapped around in an investment account. In some cases, self-directed pension plans can have PFICs. So, typical examples of self-directed pension plans will be the UK SIPP, which is the Self Invested Pension Plan.

The Self-managed Superannuation Fund in Australia, or the Swiss Pillar Three in Switzerland. Lastly, there are some bank accounts that have these money market funds, and so a good example of that is the UK stocks and shares ISA. And so I normally want to ask my clients specifically, depending on their jurisdiction, if they have these types of assets. And I'll warn you, that you have to be very specific with how you're asking that question, because to them, if you ask a broad question, do you have foreign investments? They may say no. But if you asked someone living in the UK, do you have a stocks and shares ISA or a unit trust ISA or a lifetime ISA? That typically will hold these types of PFIC investments, and then they will say yes, because you are specifically identifying what type of asset they have. So be careful about asking broad questions and really try to drill down into the various specific type of asset that the person has. Okay, so, I've mentioned a couple times that PFICs are bad. Why are they so bad? On the slide here that says, why are PFICs bad? What the client normally expects is that they're gonna get qualified dividend treatment, long term capital gains. Maybe they're gonna pay something between 15% to 23.8%.

However, what they get is they get ordinary income tax, in some cases, they get an additional interest charge, which is how the 1291 rules work and they get a tax more like along the lines of 50%, 70%. So, let's take an example here so everyone can understand why this is so bad. Let's assume that we have a PFIC that an individual has held onto for 10 years, and they get $100 gain from that PFIC in your 10. What will happen is that we will throw that $100 gain back over 10 years, and we'll tax the gain proportionately for all 10 years. So for example, in year one, we'll allocate a gain of 10, year two, a gain of 10, et cetera, et cetera. In year one, we take the gain of 10 times the highest tax rate for that particular year, so it could be 39.6, it could be 37, depending on what year it falls into. And this is regardless of what the taxpayer's bracket is or whatever tax rate they fall into. So you take the highest rate, you multiply it times 10, and then you also add in the interest charge, which is the interest that should have been paid on the tax in that year. Then we do that for years one through nine, year 10 is treated a little bit differently, but then you add it all up and that's the tax that is due. And it comes in after the fact, it's an after the fact calculation. And so what you'll normally see on page two of the tax return is you'll see this ADT tax, which is the PFIC tax, it'll show up there at the end, and it'll be, it kind of been afterwards. And so it's a little difficult to track. There are special forms that show the actual calculation of the PFIC tax. There are many ways to get out of having a PFIC, and if this is a, the next slide is the PFIC options. This is a snip from page one of form 8621.

You'll see that there are different elections, A through H, there are purging elections, there are private letter rulings that can be requested. The mark-to-market election is on here, so is the qualifying electing fund election. Those typically have to be done in the first year that you hold the asset. So, make sure that you do some PFIC planning with your client, especially if you can get them early enough on in their tax residency period, to guard around really punitive treatment. Moving on, cryptocurrency. So cryptocurrency is a huge hot button topic with the Internal Revenue Service. They've created several specialty agencies within the IRS. There's the Office of Fraud Enforcement, there are all sorts of private contractors, chain analysis is one of them that are working to help the IRS identify cryptocurrency gains or losses. I went to a presentation a couple years back where basically the IRS had identified that a 12% of all adults had a cryptocurrency transaction. This was prior to the pandemic. And basically, I think only less than 1% had actually reported that transaction. So at that point in time, there was a huge Delta of the reporting for cryptocurrency. However, since the pandemic, the usage of cryptocurrencies become more common place. You can't watch a sporting event these days without seeing a cryptocurrency commercial. There are stadiums around the country that have been renamed for cryptocurrency exchanges.

So it's become a lot more prevalent, a lot of people I see are investing in crypto through their cell phone. So that's something that we call gamification. And so the IRS knows that this is a huge market, and there are a lot of folks that are just doing small investments, up to a lot of folks that have become crypto-millionaires overnight. And so, there's an expectation that on tax returns going forward into the future, that there will be a significant amount of cryptocurrency gains or losses being reported. Those gains or losses typically are reported on schedule D, form 8949, and that's the F box that you would check, because a lot of that stuff is not issued to the IRS on a 1099. Although I will tell you that the infrastructure bill that was passed in 2021 now requires certain types of 1099 reporting for certain crypto brokerages. So, this may change in the future as far as what type of form 8949 election that you'll make or box that you'll check when you're reporting the crypto gains and losses to the IRS. You also need to be very, very careful on the question on page one of the 1040. You'll see, I've put it here on the slide and I've highlighted it on yellow. It basically says, did you receive sell exchange or dispose of a financial interest in any virtual currency?

If you did have something like that happen, you should check that box. By not checking that box, we can surmise that it may be something that's against your interest, basically saying to the IRS, if you've had these transactions, but you don't check that box that you're willfully not reporting them. And the standard or the penalties for willfulness are a lot worse than non-willfulness. You definitely want to be in the non-willful category when it comes to crypto penalties, the same would be said for foreign financial asset reporting. So make sure that if you do have a crypto transaction, that that box is being checked. Going back to our tax exempt to visa holders. Again, these are gonna be your A, G, F, J and M visa holders. There's a rule that a lot of people don't know under internal revenue code 871 A2, that says if these tax exempt visa holders, basically individuals that whose days don't qualify under the substantial presence test, so, they're treated like non-resident aliens. However, they're in the U.S, they're living in the U.S, they're residing in the U.S, if they're in the U.S from more than 182 days, which is the 871 A2, then they're subject to a 30% tax on worldwide capital gains from the sale of personal property. And so we see a lot of these individuals that have also maybe invested in cryptocurrency or set up some kind of cryptocurrency profile. They would also then have to report those gains on schedule NEC. The same would be said about foreign investments. If they have foreign brokerage accounts and they divest of the assets, those gains would also be reported on schedule NEC as well under the 30% tax. That's opposed to this next slide, which shows the normal capital gains tax rates. And remember I said that capital gains tax rates apply in tranches.

So, for example, if I had a $470,000 capital gain and I was single, the first 40,000 is gonna be taxed zero, the next 40,401 to 445,850 is taxed at 15. And then anything above that is tax at 20%, you would also then need to add on the net investment income tax, which is the next slide. The net investment income tax is 3.8% as I indicated earlier, and normally applies to an individual that's single when their income exceeds $200,000, or married, filing joint, when income exceeds $250,000. These rules can be found under internal revenue code 1411, and you will typically report the tax or calculate the tax on internal, or IRS form 8960. One of the things that you have to be careful with on the form 8960 is that you may have to make adjustments or inclusions for PFICs or controlled formed corporate inclusions. So there are some tie-ins to international gains that may need to be done on the calculation form 8960. Lastly, if you have a U.S taxpayer that is a resident, married to a non-resident alien, the general rule is that you're not allowed to file jointly.

However, there's an exception to this where you can make what's called a 6013 G-election. That election allows the resident and the non-resident to file a joint tax return. When doing that, the non-resident agrees to be taxed as a U.S tax resident. And there are some special elections that non-residents should consider for the form 8960. It clearly says this at the top of the form. So be very careful when you have a couple that is a resident, a non-resident under a 6013 G-election for purposes of the 8960. When you have capital gains or losses, make sure that you're informing your client of the estimated tax payment, rules and information returns that need to be filed. So for example, if you have estimated tax payments that are due, these are typically gonna be done on a quarterly basis. And so you're gonna have to look at where your capital gains are falling into. So for example, if I sold a home between January 1st and March 31st, I'm gonna want to calculate my estimated tax payments at both the federal and state levels during that period, and I will wanna make an estimated tax payment by April 15th.

Now let's say I'm doing the safe harbor, which is calculated on prior year income, and that's already set up for me, right? I have a standard amount of estimated tax payments that I'm making already to the IRS and whatever state. And perhaps I have a big capital gain or income event that occurs, maybe later during the year, let's say it happens between June 1st to August 31st. I'm gonna want to go back in and update my Q3 voucher to make sure that I'm calculating additional estimated tax payments and have those mailed in with that voucher. For the IRS that's typically done on form 1040 ES if you just Google that form, you'll see that there are four different vouchers that will pop up and you can update or change the vouchers as you go. There are also informational returns that may need to be submitted or acquired with your capital gains reporting.

So for example, if you have a U.S investment account, you're typically gonna get the form 1099B. If you're a U.S tax resident. The 1099 B will include all of your long-term and short-term capital gains. If you're a non-resident alien, what you should be getting is the 1042S, and the 1042S will basically, they'll be one for each type of income that you're getting. And if there's withholding tax applied, then you'll wanna check the withholding tax to make sure that it's proper. If the withholding tax is too much, then you're gonna wanna file a non-resident return to reclaim the withholding tax back. If it's too little, then you're gonna have to file the non-resident return to pay the additional tax due. In some cases, when you have a true non-resident alien that lives in a treaty country, the withholding tax rate may be less under the treaty. And that's typically where people don't set their accounts up properly, is they don't properly tell the withholding tax agent or the broker that they're in a treaty country and perhaps the dividend or the capital gain has to be withheld at a lower tax rate, or in some cases at zero. Remember, U.S capital gains tax rates only apply to non-residents if they're physically located inside the United States for more than 183 days.

So if you have a non-resident that has a brokerage account, say maybe they're a G4 visa holder or an A2 visa holder, they've been in the U.S for a long time, they decide to move back to their home country and somehow keep that U.S brokerage account open. If they're getting capital gains from the sale of personal property, but they're not inside the United States, then the tax on that should be zero. There should be no tax on that here in the U.S. Now there may be tax on that back in their home country or wherever they're currently residing, but the tax rate in the U.S would be zero. If you're selling real property here in the U.S, then you should be getting a 1099S, this would apply whether you're a resident or a non-resident alien. So again, make sure that you get all of your 1099 forms in a row before you're submitting your tax return, because these are going to be driving how you're gonna be reporting your capital gains and how it's gonna tie in to the IRS matching systems. And what will happen just so that everybody knows is that these 1099 forms or 1042S forms are sent to the Internal Revenue Service, and they're linked to the individual master file. And what happens is when a tax return is filed, the information on the return is then matched against the 1099s that are on file with the IRS. And if there's a mismatch, then you'll probably get a notice saying, hey, we see there's a mismatch, maybe something wasn't included or wasn't included properly. And that's where errors can come in at, and perhaps, more taxes will be assessed, maybe less taxes will be assessed and a refund will be issued, or worst case scenario, you may even be under audit or examination for under reporting. So in some cases, especially when you have a client that's not well organized, I always say that out of caution, it may be wise to go get IRS form 2848, that's the declaration of representation and call up the IRS, which I know is, can be a herculean effort.

Basically say, hey, look, IRS, I've got the 2848, I need you to provide me with wage and income transcripts for tax year 2021. When you get the transcripts, you could then match that up against what the client has provided you and see if there's anything missing or that the client has not reported to you. I will note though that sometimes the transcripts are incomplete, especially if you ask for them in February or March, you may wanna wait until the summer time to do your transcript matching because it can take time for the IRS systems to properly link up the 1099 or the withholding tax forms to the individual master file, or if you have a business, to the business master file. Proposed changes to the capital gains tax. So this has been around for quite some time. If we go back to the beginning of the slide, you'll see the capital gains tax rates have kind of bounced back and forth over the years, but they've been pretty steady since the 80s in regards to how capital gain's taxes have been working. And it's done so on purpose because there has to be something that can be relied upon by folks that are doing investments.

 You want to know that, hey, if I hold this investment for a long period of time, I'm only gonna pay the 20% tax or the 15% tax, or whatever it is. We saw though, that there were some proposed changes to the capital gains tax, tax rates that came out. And when the Biden administration was installed, basically the first kind of foray into this was the "Treasury Green Book" which was published, I believe in April of 2021. And basically the "Treasury Green Book" rehashed an old proposal that said, "Perhaps there should be a capital gains, "a fourth capital gains tax rate of 39.6, "which would be the highest tax rate." So for example, you would change the tax rate, the highest tax rate from 37% back to 39.6. And then if you had income of over a million dollars, then the 39.6 rate would apply to any capital gains that exceed the million dollars. So, let's just say, for example, I'm a high wage earner. I get, my wages are about $800,000, and then I have capital gains of $400,000. We're just gonna keep this math simple here. The $200,000 of the capital gains would fall under the normal capital gains tax rates. And then the $200,000 in excess of a million dollars would be taxed at 39.6.

However, you also have the net investment income tax, which is a 3.8%, so you'd end up at 43.4%. So that's a pretty pretty high rate of taxation that's being proposed in the "Treasury Green Book." And supposedly the U.S Senate was supposed to take this provision and add it in as well, this was also going to apply to potentially estates. So for example, when someone passed away, you would still get the step up in basis that we talked about earlier, but there would be a deemed or imposed capital gains tax on the estate before you got to that point. So for example, let's go back to my scenario, I'm a high income earner, I'm making 800,000, I've got 400,000 of appreciation in an investment account. I pass away, the person that inherit my investments, basically what would happen is that if the executor of my estate would have to file my final U.S tax return, the estate would have to pay this enormous amount of tax on the appreciation. And then the person that inherits my investments would then get that step up and basis at that point in time after the estate has already paid the tax.

Now, likely the estate may not be liquid enough to pay that tax. So it may have to liquidate some of those assets in order to get the funds to pay the tax due. So, those were some things that were kind of being tossed around in that "Treasury Green Book" as well as a potential payment plan of the imposed capital gains tax that's due at death. The house and the Build Back Better Act was taking a different position on this. And basically their position was, look, we're not gonna raise the capital gains tax rate to 39.6%, but we are going to increase the top rate from 20% to 25%, which means the capital gains, the highest rate would be 28.8 when you add in the investment income tax. And so at the end of the day, what would had to have happened would be that the Senate house would've had to wrangle over these proposed changes and agree to one final amount, which would've been in the final Build Back Better Act. However, the Build Back Better Act was not passed. It's to be determined if in future, a future kind of act would come into play that would change the capital gains tax rates. The last thing to note here is the U.S exit tax. So, the U.S exit tax generally occurs when you have a U.S citizen that gives up their citizenship, or you have a long term green card holder that gives up their green card. And typically by long term, what we mean is a green card holder that has held the green card for eight outta the last 15 years. And when we say eight outta the last 15 years, you need to make sure to do it, the counting of that under IRS math, not normal math. So for example, if I get my green card on December 31st of 2019, that's gonna be one year. If I have my green card on January 1st, 2020 that's two years, January 1st of 2021 is three, January 1st of 2022 is four years and so forth and so forth. So when I get to the eighth year on January 1st, I'll be at what's called a long term lawful permanent resident. To give up the green card, you typically have to do a voluntary renunciation. You can't just let it expire at least for tax purpose. And that's done under immigration form I407.

To give up the citizenship, you have to go into the consulate and you have to fill out a wide variety of forms. Typically it takes two interviews, and then you'll get your loss of renunciation paper signed and sent in. When this occurs, though, you'll have to submit to the IRS, your final dual status tax return and the exit tax form 8854. On the exit tax form 8854, you're gonna have to calculate the exit tax, which falls under three different types of taxes. There's the mark-to-market tax, there is the alternate exit tax, and then there is the PFIC excess distribution tax if you have PFICs. Typically the mark-to-market tax, the reason why I'm going into all of this is because the mark-to-market tax is a capital gain.

Basically, there are certain assets that you are going to take the basis of, and the basis determination is different for a U.S citizen than it would be for a green card holder. But you're gonna determine your basis, if you're a U.S citizen at the time you acquired the property, if you're a green card holder, you can make an election to have that basis stepped up to the date you became a green card holder. Then you're gonna determine the value of the property on the day before you either gave up your green card or the day before you got, you signed that loss of nationality document. So it's really important to take a snapshot of what those assets, what the fair market value is of those assets on that day. You're gonna calculate the gain on schedule D form 8949. It's going to be a Phantom deemed gain under internal revenue code 877 cap A. It's gonna be a long term gain.

There is gonna be a lifetime annual exclusion, which I believe is now 767,000. It goes up every year with inflation that you'll subtract from that gain. And then whatever that gain comes out to be, you are gonna be taxed at whatever the capital gains tax rates are. So for example, if we go back to these proposed changes, right now, when you're doing exit tax planning for a client, you can say, look right now your mark-to-market capital gain is gonna be 15 or 20%. However, if you have these changes that come through that are changing the capital gains tax rates, they're also gonna change how we do exit tax and exit tax calculations. And so, for example, I think if you have someone that's looking to exit the U.S, and they're seeing that their capital gains tax rate for that mark-to-market exit is 15 or 20%, or maybe in some cases it's zero because the lifetime annual exclusion reduces that capital gain to a very low amount, that I think is a little bit more palatable than if you had say a higher capital gains tax rate at 28.8% or 43.4%.

So, there's a couple things you have to think about should these changes occur when you're talking about not only how to plan for capital gains investments, cryptocurrency investments, any changes that may be tied into when someone passes away for estate tax purposes or the income tax purposes of the estate prior to the final filings, and lastly to the exit tax mark-to-market calculations. I will note that the two, for those that are wondering, the two alternative tests for the exit tax, the alternative test and the PFIC tax test, basically those come out as ordinary income. They don't get the lifetime exclusion applied to them. So they can be very dangerous, as far as what the inclusion amounts are. And they typically are large amounts that are taxed at the highest ordinary income tax rates. So for example, if I had a foreign pension that had say $400,000 in it, that pension is typically not gonna fall under the mark-to-market rules of the exit tax. And so what's gonna happen is I'm gonna be deemed to receive the full amount of that pension. Let's assume the $400,000 is what my inclusion amount is, that's gonna come in as ordinary income and probably gonna be taxed at 37% on my final dual-status income tax return.

So, to conclude with the exit tax, it's important that you kind of walk through what assets are falling under what category of taxation, and then working the math through to understand what rates would apply to the deemed or Phantom gain that occurs when you do have an exit tax event happen. And that concludes the presentation on capital gains tax, I hope everyone found this useful and helpful on a go-forward basis, thank you.

Start your FREE 7-day trial
Preview this course and the rest of Quimbee's CLE library for free with a 7-day free trial membership.
Buy this course - $49
Get access to just this course for $49

Course materials

HandoutSupplemental Materials

Practice areas

Course details

On demand
1h 00s

Credit information