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What Is a Capital Gain Exemption?

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  • Written By: Mary McMahon
  • Edited By: Nancy Fann-Im
  • Last Modified Date: 03 December 2016
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A capital gain exemption is an exclusion from the rules that normally apply to realization of capital gains for tax purposes. Under normal circumstances, when a taxpayer realizes a capital gain, it is taxable as income and must be reported on tax documentation. In some situations, an exemption may apply, and while the gain must be reported, the taxpayer does not owe taxes on it. Tax authorities determine when and where exemptions apply, and the rules often change, so it is important to look them up before engaging in an activity that might result in a capital gain.

Capital gains are profits realized through the sale of capital assets. A classic example occurs in the sale of real estate. A taxpayer buys a piece of real estate at a set price and resells it at a higher one. The difference between the prices is a capital gain, and would be treated like income. It is also possible to take capital losses; that same property owner might sell at a loss from the previous price, and would record it as a loss on taxes.

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Under a capital gain exemption, the taxes that would normally apply do not. Such exemptions are limited and tightly enforced to minimize the possibility of abuse on the part of taxpayers. In the United States, for instance, people may qualify for a capital gain exemption when they sell their primary residences. The law defines “primary residence” with care to avoid situations where property owners improperly claim an exemption.

Claiming a capital gain exemption requires recording the details of a sale and then indicating that it is exempt. An accountant can review the details to determine if a sale qualifies. If it does not, the gain will need to be taxed. Failure to declare capital gains appropriately can subject people to penalties, including jail time and fines for fraud if the false declaration is deliberate. Making a mistake, like accidentally claiming an exemption in good faith, will result in the need to amend the tax return and pay the tax, but shouldn't trigger other legal penalties.

Taxes are only due on capital gains when they are realized, which makes a capital gain exemption relevant at the time of sale. The hypothetical homeowner sitting on a home with increasing value has theoretical capital gains, but owes no taxes and does not need to declare them. As soon as the home sells, the gain is realized, and this triggers reporting and taxation requirements. Because tax codes can change from year to year, people considering the sale of assets subject to capital gains taxes may want to discuss the timing with a tax accountant to find out when they should sell.

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