Two ways that taxes are paid are well-known to most people: income taxes or sales taxes. Independent contractors, self-employed people and others pay income taxes based on the amount of money earned. Income taxes can be withheld automatically from your paycheck. When we purchase retail goods or services, sales taxes are paid at the point where we make the purchase.
Capital gains taxes are another type of tax that is often misunderstood.
What Assets are eligible for Capital Gains Tax?
Capital gains taxes are due when an asset such as investment securities or real estate is sold for less than the amount paid for it.
Investment management is all about tax efficiency. Get the guide 5 Tax Hacks to Investors and learn how you can keep increasing your net worth.
How Capital Gains are Calculated
Capital gain is calculated by subtracting the asset’s purchase price from its selling price. If you buy a stock at $1,000 and sell it at $2,000, your capital gain would be $1,000. This $1,000 capital gain will be subject to tax in the tax year that you sell the asset.
Simply put: Capital Gain = Selling price – Purchase price
Capital gains are only subject to tax if they are realized or sold. You can hold on to the stock rather than selling it. This is known as an unrealized capital loss. The gain would not be subject to tax unless the asset is sold.
Capital gains are subject to tax at a different rate depending on how long the asset has been held. Your gain on capital gains will be taxed at long-term capital gains rates if you have held the stock for more than one year. However, if you have a stock for less time than one year before selling it your gain will be subject to ordinary income tax.
Rates of Capital Gains in 2022
The adjusted gross income (AGI) is the basis for long-term capital gains taxes rates. Based on your taxable income, the basic capital gains rates range from 0% to 15% and 20% to 20%. Inflation affects the income thresholds for capital gains tax rates.
|
Capital Gains
Tax Rate |
Taxable income
(Single) |
Taxable income
(Married Filing Separately) |
Income that is taxable
(Head of Household). |
Taxable income
(Married Filing jointly) |
| 0% | As high as $41,675 | As high as $41,675 | Maximum $55,800 | Maximum $83,350 |
| 15% | $41,676 – $459,750 | $41,676 – $258,600 | $55,801 – $488,500 | $83,351 – $517,200 |
| 20% | More than $459,750 | More than $258,600 | More than $488,500 | More than $517,200 |
Due to a special exemption, capital gains on primary dwellings are treated differently than other real estate. Your income for the year is exempted from the first $250,000 of your home sale gain, provided you lived in the house for at least two years. The exclusion for married couples filing jointly is $500,000.
Avoiding Capital Gains Taxes or Minimizing Their Impact
There are many strategies that you can use to minimize or avoid capital gains taxes. These are the four key strategies.
1. For the long-term, keep your taxable assets.
To lower your capital gains taxes, you can simply hold taxable assets for a year or more to take advantage of the long-term capital gain tax rate. Although marginal tax brackets and capital gain tax rates can change over time, the tax rate for ordinary income is generally higher than that for capital gains. It is a good idea to keep your taxable assets at least for one year, if you can.
2. You can make investments in tax-deferred retirement plans.
Capital gains are not subject to tax if you sell or buy investment securities within tax-deferred retirement plans such as IRAs or 401k plans. Capital gains are not subject to tax until you withdraw funds from retirement. At that time, you might be in a lower tax bracket.
Retirement account funds can grow tax-deferred, so account balances could grow more than if capital gains taxes were imposed pre-retirement. This is what Roth IRAs, 401k plans and other retirement accounts do. Capital gains taxes are not assessed even if funds are withdrawn in retirement. As long as certain rules are observed.
3. Use tax-loss harvesting.
This strategy involves selling investments that are not performing and taking a loss. These capital losses can be used to offset taxable investments gains and up to $3,000 per year of ordinary income. You can carry forward any unutilized investment losses in the future to offset capital gains or ordinary income.
Let’s say you made a $5,000 taxable profit on a stock sales this year. But, your stock has dropped in value by $2,000 and it is unlikely to recover soon. This stock could be sold, and the $2,000 loss can be recorded. The taxable gain on the stock will then be reduced to only $3,000.
Important to remember that stock sold at a loss can be bought back if it is returned within 30 days. The “wash-sale” rule will prevent you from using capital gains to offset losses if you purchase it back earlier than that.
Read more: Guide for Tax-Loss Harvesting
4. Donate appreciated investments for charity
Donate to charity investments that have appreciated in value since you bought them. The charitable donation tax deduction will be applied to the fair market value of your investment at the date of charitable donation. Capital gains tax will not be charged on investments donated to charity.
Read More Tax-Wise Charitable Gift: Donating Appreciated Assets
Capital Gains on Real Estate
Tax law allows for a capital gains exclusion of up $250,000 (or $500,000 if married couples filing jointly) on the proceeds of the sale of a property.
These rules will apply to this exclusion.
- Only a home is eligible if it is your primary residence. This does not apply to rentals.
- At least two years must have passed since you moved into the house. You don’t have to live in the house for at least two years consecutively.
- This exclusion is only available once every two years.
Calculate your cost base to accurately determine how much you will owe. Add up the sale price and the cost of any home improvements that have a longer useful life, as well as the expenses associated with buying and selling the home. The first includes closing costs, title insurance, settlement fees, and real estate commissions. The latter include attorney’s fees and real estate fees. To calculate your taxable profit, subtract the full price of the home from its sale value.
These costs can be deducted from the sale price of your home to lower your capital gain. This could make a big difference if you are right at the $250,000/$500,000 threshold.
Rental Real Estate
Section 1031 of the tax code allows you to defer capital gains tax on any profit made on the sale or lease of a rental property. This is done by rolling the proceeds into a new property. To properly complete the 1031 exchange, you must follow specific rules. You can use a qualified intermediary escrow firm to assist with this type of transaction.
Once the property is sold, the capital gains tax bill will have to be paid. Real estate investors who are savvy may choose to delay capital gains on rental properties indefinitely and continue to use 1031 exchange transactions to sell all their rental properties.
Dig Deeper
How can I avoid paying capital gains taxes on stocks
There are several ways to reduce the capital gains tax you pay on the profits from stock sales. You have the option to claim your fees as a deduction or use tax-loss harvesting. Or, you can invest in tax-advantaged retirement funds.
Capital gains tax brackets – What are the tax brackets applicable to capital gains?
Taxes are charged at the ordinary rates of 10% to 37% on short-term capital gains. Your income does not include long-term capital gains. They are taxed separately. Your taxable income will determine whether long-term capital gains are subject to tax at 0%, 15% or 20%.
What is the difference between short-term capital gain and long-term capital gain?
The difference between short-term and long-term capital gain and capital loss is how long the asset has been owned and how much tax you will be subject to. Short term refers to 12 months or less, while long term refers to more than 12 months.