A capital gain occurs when you sell something for more than you spent to acquire it. For example, if you bought stock for $3,000 and sell it for $5,000, you have a capital gain of $2,000. That gain is taxable, and you’ll need to report it to the IRS. The IRS even has a specific way of determining capital gains tax that differs from earned income taxes.
So what are capital assets?
The ones most people think of are stocks, bonds, and other investment vehicles like futures. That’s only the tip of the iceberg though. Your home, vehicle, furniture, and even clothing can be considered a capital asset. The IRS says capital assets are “almost everything you own and use for personal or investment purposes.” A notable exception to the IRS’s taxation method for capital assets are collectibles. Collectibles are taxed at your marginal tax rate up to a maximum of 28%. If you hold them for less than one year, there is no 28% ceiling.
How are capital gains taxes determined?
To start with, the system is designed to encourage long-term investing, so the tax bite from short-term gains is significantly larger than that from long-term gains. If you sell an asset that’s appreciated that you’ve owned for a year or less, it’s a short-term capital gain and you’ll pay a higher capital gains tax rate on such investments.
If you sell an investment asset after owning it for more than a year, any gain you have is a long-term capital gain. That difference in tax treatment is one of the advantages a buy-and-hold investment strategy has over one that involves frequent buying and selling, such as in day trading.
People in the lowest tax brackets usually don’t have to pay any tax on long-term capital gains. The difference between short- and long-term gains, then, can literally be the difference between having to pay taxes and no taxes.
There are ways to anesthetize your tax bite: because investments don’t always go up in value, if you sell something for less than what you paid for it, you have a capital loss. Capital losses from investments can be used to offset capital gains. So, for example, if you have $50,000 in long-term gains from the sale of one stock but $20,000 in long-term losses from the sale of another, you may only be taxed on $30,000 worth of long-term capital gains.
If capital losses exceed capital gains, you may be able to use the loss to offset up to $3,000 of other income. If you have more than $3,000 in capital losses, the excess can be carried forward to future years to offset income in those years.
And we wouldn’t want to overlook tax brackets: the amount an investor is taxed depends on his or her tax rate.
Short-term capital gains are taxed at the investor’s ordinary income tax rate. Long-term capital gains are taxed at 15 percent for individuals in the lowest two income tax brackets, while a 20 percent rate hits those in the 39.6 percent tax bracket. And these amount can change over time, so you have to check the most recent rules.
As you can see, there are a lot of complexities here, so you should really know what your situation is before you sell a security. Give us a call first, and we’ll help you plan for the taxes you have to pay and advise you on the most tax-efficient ways to manage your portfolio.
