(c) 2012 Earl L Haehl – Permission is granted to redistribute this in whole as long as credit is given. Book rights are reserved.
Capital gains occur when the value of property changes in dollars. This can be due to value added to the property through the efforts of the owner, changes in value due to market forces such as scarcity or demand or changes due to inflation or government action. While there are those searching for revenue who define this as income, this is a change in the value of property, not income.
The first may example may be the fixer-upper house that a person buys for its market value when it has, through neglect, vandalism, natural disaster etc., lost much of its value. While no one actually buys a house, but rather the real estate upon which it sits—except in the case of a condo. But the condition of a dwelling or other building on the premises impact what will be paid for the land. The person buying as investment had better know what it will cost.
Hypothetical 1: In 1986 we looked at what would be ideal for a couple writers who had the wherewithal to handle the utilities, stairs etc. As we walked through the place, I noted the wiring—at least $10,000 to make it fire safe, double that for computers. I would have gone through it with a plumbing contractor as well, but as we stepped outside I noted a foundational crack. The hypothetical person (Hyp1) who bought the house at a bargain price was going to spend an additional two to three times in upgrades. So look at the house at $50,000 (remember this was 1986) plus $125,000 (conservative) in repairs and then it gets sold in the bubble for a quarter million. It was purchased at fair market value, it was sold at fair market value. What was sold was the property for which Hyp1 sold not only the house for which $175k was the cost basis, but also the future use of the property and the fact that a comparable or greater price would be necessary to replace it.
Hypothetical 2: So in October 1987 a different hypothetical buyer purchased 100 shares XYZ Corp at $29. This was fair market value the day after the big correction. But the income from the stock was solid and the seller had panicked. In other words the fair market value was impacted buy panic, not performance but it was still fair market value on that day. I March of 1998 our hypothetical buyer decided to get into the burgeoning green energy industry so he looked at his XYZ that had split twice and was now valued at $129 with a cost basis of $80 since the last split. Hyp2 sold 200 shares and was bought Greeniecorp which filed bankruptcy in December. Had he not taken the bath on Greeniecorp he would have paid capital gains tax on $9,800. In selling those shares Hyp2 sold all future interest and income that would accrue to those shares, not merely notes.
The second category involves market forces. And it still involves purchase and sale at fair market value. In this case, the ultimate seller relinquishes the value and future interests as well as the property itself.
In the third scenario, inflation or other government action, there is no change in the value of the property—there is a devaluation of the money. To call the change in price a gain is wrong. The government has, through its actions change the value of the exchange and should not benefit by taxing the difference.