Capital Gains Made Simple
Buying and selling items that result in a profit — such as investments, real estate or collectibles — can trigger an expense that many people don’t see coming: capital gains tax. Understanding how this tax works, and when it comes into play, can help you plan ahead — and keep more of what you earn from these types of sales.
What Counts as a Capital Gain?
A capital gain occurs when you sell an asset for more than you paid for it. If you sell it for less, you have a capital loss. The amount you originally paid for the asset, adjusting for certain fees or improvements, is known as your cost basis. Your taxable gain is generally the difference between your sale price and cost basis.
For example, if you buy a home for $300,000, spend $25,000 on qualifying
improvements over the years, and later sell it for $375,000, your starting gain would be $50,000. After subtracting certain qualifying selling costs, such as real estate commissions and closing fees, your taxable capital gain would be $20,000, assuming no other applicable tax rules or exclusions apply.
And that gain is only realized, for tax purposes, when the asset is sold. If your asset appreciates in value during the time you own it, you generally won’t owe capital gains tax ... yet. This increase is called an unrealized gain. So, when you buy a piece of art that rises in value over several years but stays in your possession, no capital gains tax applies until you decide to sell it.
Timing also matters. Assets held for one year or less typically fall into the short-term category and are taxed at ordinary income tax rates. Assets held longer than one year qualify for long-term capital gains rates, which are usually lower.
Many additional rules — such as those for inherited property, depreciation of certain assets and rules specific to certain types of investments — can affect how gains are calculated and taxed. Because these rules can significantly change the tax outcome, it’s important to understand which ones apply to your situation — and not assume every gain is taxed the same way.
Federal and State Tax
At the federal level, long-term capital gains are taxed at different rates depending on your income and filing status. Many taxpayers fall into the 0%, 15% or 20% brackets, although certain assets and situations may be subject to different rates or additional taxes. Short-term gains are taxed at the same rate as wages or other income.
Some states impose their own capital gains taxes, while others don’t tax investment gains at all. High-income taxpayers may face an additional charge known as the net investment income tax, which can add a 3.8% surtax on certain investment income once income exceeds specific thresholds.
Ways to Reduce Capital Gains Taxes
Several strategies may help limit the impact of capital gains taxes:
• Use tax-advantaged accounts. Investments held inside accounts such as 401(k)s or IRAs grow without triggering capital gains as they’re bought and sold within the account.
• Hold assets longer. Long-term capital gains rates are typically lower than short-term rates, which can make patience financially rewarding.
• Offset gains with losses. Selling an asset at a loss can help offset gains from other sales, reducing your overall tax exposure.
• Take advantage of the primary residence exclusion. Homeowners may be able to exclude a significant portion of gains on the sale of a primary home if ownership and residency requirements are met.
• Time sales strategically. Selling assets in years when your income is lower may result in a lower tax rate.
Because tax rules can be complex and change over time, and personal circumstances vary, working with a Financial Professional or tax advisor can help ensure strategies align with your broader financial goals.
Planning Pays Off
Capital gains taxes don’t have to be intimidating. With a basic understanding of how gains are calculated and taxed, along with thoughtful planning and some professional guidance, you can help reduce surprises and make more informed financial decisions.
Sources
https://www.irs.gov/taxtopics/tc409
https://www.investopedia.com/terms/c/capital_gains_tax.asp
https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax