Capital Gains Tax: What It Is, How It Works, and Current Rates

Capital Gains Tax Exceptions: Collectibles, Real Estate, & Investments

Some asset categories are subject to different capital gains tax treatment than the norm.

Collectibles

Short-term gains on collectibles, including art, antiques, jewelry, precious metals, and stamp collections, are taxed as ordinary income at graduated tax rates. Net long-term gains on collectibles are taxed at a maximum rate of 28%.

Owner-Occupied Real Estate

Real estate capital gains are treated differently if you sell your principal residence. Up to $250,000 of the capital gains from the sale of your home is excluded from taxable income. This increases to $500,000 if you are married and filing jointly. You must have owned and lived in the home for at least two of the five years before the sale to qualify for this tax break.

Capital losses from the sale of personal property, such as a home, aren’t deductible from gains, however.

A single taxpayer who buys a house for $200,000 and sells it later for $500,000 realizes a $300,000 profit. After applying the $250,000 exemption, they must report a $50,000 capital gain. This is the amount subject to the capital gains tax.

Investment Real Estate

Real estate investors can claim depreciation deductions to account for regular wear and tear as the property ages. Wear and tear reflects the home’s physical condition rather than its change in value.

The depreciation deduction reduces how much you’ve paid for the property. That can increase your taxable capital gain if you sell because the gap between the property’s value after deductions and its sale price will be greater.

If you paid $100,000 for the building, you’d be taxed as if you’d paid $95,000. You can claim $5,000 in depreciation, which is then treated as a recapture of those depreciation deductions when you sell:

• The tax rate applied to the recaptured amount is 25%, so you’d have gains of $15,000 if you sold the building for $110,000.
• Then, $5,000 would be treated as a recapture of the deduction from income. This amount is taxed at 25%.
• The remaining $10,000 of capital gain would be taxed at 0%, 15%, or 20%, depending on your income.

Investment Exceptions

You may be subject to the net investment income tax if you have a high income. This tax imposes an additional 3.8% on your investment income, including your capital gains, if your modified adjusted gross income (MAGI) exceeds certain maximums.

The threshold amount is:

• $200,000 for single filers and heads of households
• $250,000 for married couples filing jointly and surviving spouses
• $125,000 for married couples filing separate returns

Calculating Your Capital Gains

Capital losses can be deducted from capital gains to calculate your taxable gains for the year. The calculation becomes more complex if you’ve incurred capital gains and capital losses on short-term and long-term investments.

First, sort short-term gains and losses into a separate pile from long-term gains and losses. All short-term gains must be reconciled to yield a total short-term gain, and then the short-term losses are totaled. Then tally your long-term gains and losses.

Short-term gains are netted against short-term losses to produce a net short-term gain or loss. The same applies to long-term gains and losses.

How to Reduce Capital Gains Tax Legally

You’ll owe capital gains tax on the profit if you want to invest money and make money. You can minimize your capital gains taxes in several ways, however.

• Hold your investment for more than one year. Otherwise, the profit will be treated as regular income, and you’ll most likely pay more.
• Don’t forget that your investment losses can be deducted from your investment profits. You can claim $3,000 in losses a year. Some investors use this benefit to good effect. They’ll sell a loser at the end of the year to offset their gains. You can carry any excess losses forward and deduct them from future capital gains if your losses exceed $3,000.
• Keep track of any qualifying expenses you incur in making or maintaining your investment. They will increase the investment’s cost basis and reduce its taxable profit.
• Be mindful of tax-advantaged accounts. Securities can limit the liquidity of a 401(k) or IRA, as well as your withdrawal options. However, you may have greater capabilities in buying and selling securities without incurring taxes on gains.
• Seek out exclusions. If you want to sell your house, understand the rules that let you exclude a portion of gains from the sale. If possible, intentionally meet the criteria to plan the timing of the sale and ensure that you meet exclusion requirements.

Capital Gains Tax Strategies

The capital gains tax can reduce the overall return generated by an investment, but there are legitimate ways to reduce or even eliminate net capital gains taxes for the year.

The simplest way is to hold assets for more than a year before selling them. The tax you’ll pay on long-term capital gains is generally lower than it would be for short-term gains.

Capital Losses and Tax-Loss Harvesting

Capital losses offset capital gains and effectively lower your capital gains tax for the year, but what if the losses are greater than the gains?

You can claim the amount against your income if your losses exceed your gains by up to $3,000. The loss rolls over, so any excess unused loss above $3,000 in the current year can be deducted from income to reduce your tax liability in future years.

Say an investor realizes a profit of $5,000 from selling some stocks but incurs a loss of $20,000 from selling others. The capital loss can be used to cancel out tax liability for the $5,000 gain. The remaining capital loss of $15,000 can then be used to offset income and the tax on those earnings.

The investor whose annual investment income is $50,000 would report $50,000 minus a yearly maximum claim of $3,000 in the first year. That leaves a total of $47,000 in taxable income. The investor still has $12,000 in capital losses and can deduct the $3,000 maximum yearly for the next four years.

Don’t Break the Wash Sale Rule

Be mindful of selling stock shares at a loss to get a tax advantage only to buy the same investment again. You’ll run afoul of the IRS wash sale rule against this sequence of transactions if you do it within 30 days or less.

Material capital gains of any kind are reported on a Schedule D form.

Use Tax-Advantaged Retirement Plans

Among the many reasons to participate in a retirement plan like a 401(k) or an IRA is that your investments grow from year to year without being subject to capital gains tax. You can buy and sell within a retirement plan without paying taxes every year.

Most traditional tax-advantaged retirement plans don’t require participants to pay tax on the funds until they’re withdrawn from the plan. Withdrawals are taxed as ordinary income regardless of the underlying investment.

Cash in After Retiring 

Consider waiting until you stop working to sell profitable assets. The capital gains tax bill might be reduced if your retirement income is lower. You may even be able to avoid having to pay capital gains tax.

Be mindful of the impact of taking the tax hit while you’re working rather than after you’ve retired. Realizing the gain earlier might serve to bump you out of a low- or no-pay bracket and cause you to incur a tax bill on the gains.

Watch Your Holding Periods

Remember that an asset must be sold at least a year or more after it was purchased for the sale to qualify for treatment as a long-term capital gain. Be sure to check the actual trade date of the purchase before you sell if you’re selling a security that you bought about a year ago. You might be able to avoid its treatment as a short-term capital gain by waiting only a few days.

These timing maneuvers matter more with large trades than small ones.

Choose Your Basis 

Most investors use the first-in, first-out (FIFO) method to calculate the cost basis when they acquire and sell shares in the same company or mutual fund at different times. However, there are four other methods to choose from:

Your best choice will depend on several factors, such as the basis price of shares or units purchased and the amount of gain that will be declared. For complex cases, you may want to consult with a tax advisor.

Computing your cost basis can be a tricky proposition. Your statements will be on its website if you use an online broker. Be sure you have accurate records in some form in any case.

Determining when a security was purchased and at what price can be a nightmare if you’ve lost the original confirmation statement or other records. This is especially troublesome if you have to determine precisely how much was gained or lost when you’re selling a stock, so be sure to keep track of your statements. You’ll need those dates for the Schedule D form.

The Bottom Line

Capital gains taxes are levied on profits made from the sale of assets like stocks or real estate. The tax is based on the holding term and the taxpayer’s income level and is computed using the difference between the asset’s sale price and its acquisition price. It can be subject to different rates.