Taxation Issues - Federal Income Tax Regulations
An individual may be subject to one of these four types of income tax:
Ordinary income - this includes all income earned from salary, commission, and business income. Some investment gains, such as bond interest and withdrawals from traditional IRAs and company retirement plans, are taxed at "ordinary income" rates.
Capital gains - this refers to income resulting from the appreciation of a capital asset (e.g. stocks, real estate, coins). Capital gains are not realized until the asset is sold. Capital gains are classified as short-term or long-term:
Short-term - assets held for 12 months or less are considered short-term capital gains and are taxed at ordinary income rates.
Long-term - assets held for longer than 12 months benefit from reduced tax rates (based on your marginal tax bracket). Ordinary income earners pay a capital gains tax rate of 15%, while those in who are considered to be high income earners pay 20%.
- Short-term - assets held for 12 months or less are considered short-term capital gains and are taxed at ordinary income rates.
Dividends - prior to 2003, dividends were taxed at ordinary income rates along with bond interest. Due to a change in tax law, "qualified" stock dividends (common and preferred) are now taxed like capital gains, with a maximum income tax rate of 15%. REIT dividends do not qualify for this special treatment.
- Passive income - income from sources such as real estate limited partnerships or directly owned (but professionally managed) real estate is taxable at ordinary income rates and can only be reduced by passive losses, not by capital gain losses.