Capital gains tax is a federal income tax incurred when the sale of what is termed a “capital asset” results in a profit being made — the sales proceeds exceed the cost of purchase. Capital gains tax brackets range from 0 to 39.6 percent, depending on the individual’s tax bracket and how long the asset is held. Learn how capital gains taxes affect your finances and how you can strategize your investments to minimize taxation.
1. Capital Assets Include a Range of Personal Items
The IRS definition of a capital asset includes a wide range of personal property, such as a home, car, furniture and artwork, and investment property, such as stocks and bonds. When you sell any of these capital assets for a profit — referred to as a “gain” — you incur a tax liability called a capital gains tax.
A company whose business is buying and selling assets does not pay capital gains tax. Instead, the difference between the cost of purchasing the asset and the proceeds from its sale is considered gross profit. For example, if the business buys widgets at $x and sells them for $x+$3, the $3 is profit, not capital gain. After operating expenses are subtracted, income taxes are due on the net profit.
2. Cost Basis Is Used to Determine Capital Gains Tax
To calculate the capital gains tax from the sale of an asset, you need to know your cost basis. Generally, this will be the amount you paid for the property or investment plus the costs of acquiring it. Acquisition costs, for example, include commissions, delivery, setup and installation. For some property, such as your home, the basis may include the cost of upgrades or additions you made. Putting in a pool, for example, will increase the cost basis used to calculate any gain you might realize when you sell your home. Maintenance costs, such as painting and roof repairs, are not added to your cost basis, as they do not improve the property.
To calculate your capital gain on the sale of an asset, you subtract your cost basis from the net proceeds you receive from the sale. Net proceeds are the gross amount you receive minus any costs incurred in the sale. If you sell shares of a stock, any commissions paid to a brokerage firm are deducted from the gross proceeds to calculate the net proceeds.
3. Capital Gains Are Either Long-Term or Short-Term
Capital gains are classified either as long-term assets that are held at least one year and a day, or short-term, held for less than one year. The tax rates for short-term gains are higher than those for long-term gains, providing an incentive to engage in a long-term investment strategy, rather than seeking profits from short-term trading.
4. Income Tax Brackets Affect Capital Gains Tax Brackets
Your individual income tax bracket affects the percentage of the tax assessed on capital gains. Short-term capital gains are taxed at the individual’s ordinary income tax rate, which can be as high as 39.6 percent. The maximum long-term capital gains tax rate, for the very highest income individuals, is 20 percent, and those in the lowest income tax bracket do not have to pay long-term capital gains taxes at all.
One anomaly is that the tax rate for art and collectibles is 28 percent. Currently, there are seven long-term capital gains brackets. Matched next to income tax brackets, they are:
|Income Tax Bracket vs. Capital Gains Tax Bracket|
|Individual Tax Bracket||Long-Term Capital Gains Rate|
5. You Can Offset Gains and Losses
When you fill out your annual tax return, your capital gains tax is based on net long-term capital gains and net short-term capital gains. You’re allowed to offset gains with any losses you incurred. Remember, you have to sell the asset during the tax year to trigger any capital gains or losses.
Taxpayers who have earned significant gains during the year might elect to sell assets that they’re holding at a loss near the end of the year in order to offset any gains and minimize capital gains taxes. Doing this can be difficult if the investor retains even faint hope that the losing asset might rebound in value the following year. If you sell a personal asset — such as a car, jewelry or house — at a loss, you can’t net that loss against any gains.
6. Your Home Can Shelter You from Capital Gains Tax
Owning a home for a long period of time can be a powerful wealth-building tool, because when you sell the property, the Internal Revenue Service allows you to deduct up to $250,000 — for a single filer, and $500,000 if married filing jointly — of the long-term gain you realized so that you owe nothing on that portion of the gain.
Certain restrictions apply:
- The home must have been your primary residence for at least two of the five years preceding the sale.
- The home must have been your primary residence.
- You must have resided in the home.
If you’re a single tax filer and you sold your house for $600,000 and your cost basis on the property was $250,000, your gain would be $350,000 — which, depending on your tax bracket, might result in a hefty capital gains tax. But due to the $250,000 exemption, you pay tax only on the remaining $100,000 of the gain.
7. You Can Offset Ordinary Income With the Nifty $3,000
After you’ve netted out your long- and short-term capital gains, if the result is a net loss for the year, the IRS allows you to deduct up to $3,000 of that loss from ordinary income, reducing your overall federal income tax liability for that year. Even better, if the net loss was greater than $3,000, you can carry over this additional amount and can apply it against your returns in the future. Although losing money invested in the stock market is never pleasant, this feature of the tax code allows you to recover a portion of the loss through tax deductions from the total income on your return.
8. Health Savings Accounts Can Reduce Capital Gains Taxes
Health savings accounts are custodial accounts established with an HSA trustee and used to pay for medical expenses. Your contributions to the account are tax-deductible.
When you invest the funds and they appreciate in value, you don’t have to pay taxes on the gains when you sell the investment and withdraw the funds. The key is you must use the proceeds from the sale to pay for allowable healthcare expenses. To qualify for a HSA, you must have a high-deductible health plan, and there are annual limits to the amount you can contribute to the account.
Although having to pay capital gains tax takes some of the joy out of profitable investing, with careful planning before the end of each tax year — including obtaining professional tax preparation assistance to expand your understanding of capital gains tax rates and regulations — you can reduce the amount of your tax liability.
Click through to read about the ins and outs of unrealized capital gains and losses.
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