What are Capital Gains?
Capital gains refer to the profit made from selling assets like stocks, bonds, real estate, art, collectibles, or other investments for more than their original purchase price after a certain holding period.
When you realize a capital gain, it becomes subject to capital gains tax. The rate at which these earnings are taxed depends on whether it is a short-term or long-term capital gain.
Understanding the classification and tax treatment of capital gains is important for investors to make sure they comply with local tax laws.
Types of Capital Gains
Capital gains are categorized based on how long you held the asset before selling:
Capital Gains Type
Short-Term Capital Gains
Gains realized from assets held for 1 year or less. These are taxed at the ordinary income tax rate.
Long-Term Capital Gains
Gains from assets that were held for over 1 year. These qualify for more favorable capital gains tax rates.
The holding period determines whether taxes apply at the normal income tax rate or preferential long-term capital gains rates. Generally, it is advisable to hold assets for more than a year before selling to benefit from the lowest capital gains tax rate.
However, some assets, like collectibles, are taxed at a flat rate of 28% in the US regardless of the holding period. Others, like real estate, allow for some tax-free capital gains.
So, the classification and tax impacts differ based on the type of asset sold at a gain and the holding period.
Capital Gains Tax Rates
In 2023, the federal tax rates on long-term capital gains are:
- 0% – For single filers with taxable income up to $44,625 or married filing jointly up to $89,250.
- 15% – For single filers with taxable income from $44,626 to $492,300 or married filing jointly from $89,251 to $553,850.
- 20% – For single filers with taxable income above $492,300 or married filing jointly above $553,850.
These apply to gains from selling investments like stocks and bonds. Any short-term capital gains are taxed as ordinary income at rates up to 37%. State taxes also apply in most cases.
Some assets that have special capital gains tax rates include:
- Collectibles like art, antiques, metals, and gems, are taxed at a 28% rate regardless of the holding period
- Real estate gains exceeding $500K realized by married couples are taxed at a rate of 25%.
As of 2023, only Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming don’t have state capital gains tax. However, most states levy additional capital gains taxes ranging from 2% to 13% depending on the investors’ area of residence and income level.
Avoiding Capital Gains Taxes Legally
While capital gains taxes can’t always be avoided, there are some legal ways to reduce or defer what is owed:
- Offset Gains with Losses: If you realize capital losses in a year, these can be used to offset realized capital gains. This directly lowers the amount of net capital gains that will be taxed. Capital losses in excess of gains can also offset up to $3,000 worth of ordinary income.
- Donate Appreciated Assets: By donating appreciated investments held for over a year to charity, you can legally avoid having to pay capital gains tax on the sale. Plus, you get a tax deduction for the full fair market value.
- Leverage Tax-Advantaged Accounts: Assets sold within IRAs, 401(k), and other tax-advantaged retirement plans are not subject to capital gains tax unless they are withdrawn. While contributions may not be tax deductible, gains compound tax-deferred, which fuels the long-term growth of the account’s balance.
- Claim Home Sale Tax Exclusion: For a primary residence, married couples can exclude up to $500K, and singles can exclude up to $250K of capital gains from federal taxes when selling the home under certain conditions. To be eligible, the taxpayers must comply with specific occupancy and ownership rules.
- Delay Selling Assets: Choosing to not realize capital gains yet allows for further tax deferral. As long as you don’t trigger a taxable sale, no capital gains taxes are owed yet. Time helps money compound.
Using strategies like these can help taxpayers build more wealth over time by legally reducing capital gains taxes owed. It is important to work with a qualified tax professional to implement these tactics appropriately upon assessing the investor’s situation.
Reporting Capital Gains and Losses
Tracking and reporting capital gains and losses is required when filing your annual income tax return. Investors need to have proper documentation on hand outlining dates, the assets that were acquired and sold, their cost basis, and the proceeds obtained from their sale.
Brokerage firms and mutual funds typically provide investors with 1099 forms summarizing capital gains distributions, dividends, and sale transaction information. Nonetheless, taxpayers are responsible for providing supporting evidence for other sales of assets like real estate, fine art, collectibles, etc.
Schedule D is filed with your personal tax return to report capital gains and losses for the year. This form separates short and long-term transactions by holding period.
A net capital loss of up to $3,000 can be used to offset ordinary income. Unused capital losses carry forward to future years indefinitely.
After netting any losses, the resulting net short-term capital gains are taxed as ordinary income. Any remaining net long-term capital gains qualify for the preferential capital gains tax rates based on the taxable income brackets shown earlier.
Planning for Capital Gains Taxes
Investors focused on building wealth in the long term should factor capital gains taxes into their financial strategies.
Here are some tips when planning investments and tax optimization strategies:
- Hold assets for more than 1 year whenever possible to benefit from the lower long-term capital gains rates.
- Match capital gains and losses realized in a year to offset when able to reduce net tax owed.
- Place assets with the highest expected potential to generate gains in tax-deferred accounts to maximize compounding.
- Consult a tax professional to discuss which assets may receive preferential treatment when strategizing sales.
Understanding how to efficiently manage capital gains and losses can better position investors to maximize after-tax returns in the long run.