Capital gains tax is a concept every taxpayer needs to be familiar with for proper taxation of investments and assets.
In this article:
- What Is Capital Gain?
- What Is Capital Gains Tax?
- Do I Have to Pay Capital Gains Tax?
- When Is Capital Gains Tax Paid?
- What Is the Difference Between Long Term Capital Gains Tax and Short Term Capital Gains Tax?
- How Can I Minimize the Amount of Capital Gains Tax I Have to Pay?
- How Do I Lower Capital Gains Tax on Property Sale?
Capital Gains Tax | What You Need to Know
What Is Capital Gain?
Assuming you sold something for more than your “basis” in that item or asset, then the difference is a capital gain. Simply put, it is the total sale price minus the basis or original cost of the item.
Basis Definition: The “basis” is the total amount you had to pay to acquire a specific asset. This includes not only the price of the item, but also sales, excise and other taxes, shipping fees, installation, and setup charges, etc.
For example, a stock you bought for $5,000 and sold two weeks later for $7,000 gives you a $2,000 capital gain. The same goes for your car, property, and other assets you may own.
The money you spent to increase that asset’s value (such as improvements to a building) also adds to your basis. Depreciation of the asset, on the other hand, decreases that basis.
Capital losses can also occur when you sell that asset for less than its basis. For example, selling your shares in a company when they are down may result in a capital loss.
Subtracting capital losses from capital gains gives you net capital gain. Either of the two can offset the other.
While capital losses are not ideal, you can use them to offset some capital gains you may have earned on the sale of another asset that same year. This results in a lower amount of taxes you need to pay.
To give an example, let us say you have $2,000 worth of shares in one company and $5,000 worth of shares in another. You sold your shares in the first company for only $1,500 and your shares in the second company for $6,500.
You have a capital loss of $500 in the first company and a capital gain of $1,500 in the second. This gives you a net capital gain of $1,000.
With this in mind, what exactly is capital gains tax?
What Is Capital Gains Tax?
Capital gains tax is one of the many types of taxes the Internal Revenue Service (IRS) imposes on the income from the sale of certain assets. While most people believe this tax applies only to investments, capital gains tax actually applies to all capital assets.
This includes both things you bought for investment (such as stocks, bonds, or properties) and things you bought for personal use (such as your car or your TV).
Do I Have to Pay Capital Gains Tax?
Contrary to popular belief, people from all walks of life have to pay capital gains tax. Anyone who sells a capital asset and makes income on it is liable to pay the capital gains tax.
It does not only apply to rich people who make huge profits off their portfolio. If you sell a large personal item from your home (or even your home itself) and make a profit from it, then the IRS will charge you capital gains tax from it.
When Is Capital Gains Tax Paid?
Capital gains tax is only due upon the sale of an asset.
In the case of stocks, for example, you pay taxes only when you sell your shares. You will not owe the IRS any taxes for the value it gains while it is still inside your portfolio.
Upon sale, you have to report these gains on your tax return. Only then will you pay taxes on it depending on the prevalent capital gains tax rates at the time of the sale.
Taxpayers often need to file Form 8949, Sales and Other Dispositions of Capital Assets. Additionally, they also have to file Schedule D, Capital Gains and Losses, along with their tax return.
What Is the Difference Between Long Term Capital Gains Tax and Short Term Capital Gains Tax?
Short-term capital gains or losses happen when you have owned an asset for a year or less. On the other hand, long-term capital gains or losses happen when you sell those assets after you have owned them for more than a year.
Short-term capital gains have higher tax rates compared to long-term capital gains. This is to discourage short-term trading, which can result in increased market volatility and risk.
Additionally, to individual investors, short-term trading also costs more in transaction fees.
How Can I Minimize the Amount of Capital Gains Tax I Have to Pay?
Depending on the type of investment or asset you sell, there are numerous ways of minimizing the capital gains tax you have to pay.
Waiting until you reach over a year of ownership of an asset, as mentioned earlier, is one way of reducing the amount of capital gains tax you have to pay.
Offsetting capital losses from capital gains is another way of minimizing capital gains tax.
You may also sell your long-term capital gain assets in years when your income level is about to take a dip. Selling during a low-income year (such as when you are about to retire or quit your job) is one way of minimizing your capital gains tax rate.
Using different retirement savings vehicles, such as a traditional IRA or a Roth IRA, also allows you to avoid capital gains and defer income tax.
One of the benefits of investing in a traditional IRA is you will never pay capital gains on its earnings. Because investing in this market uses pretax dollars, however, you will pay ordinary income tax upon its withdrawal.
Contributions to Roth IRAs, meanwhile, use post-tax dollars. Because of this, the IRS will no longer collect taxes when you withdraw from it.
Because your capital gains rate depends on your income, making the most of your tax deductions and credits before filing your tax return is a good strategy. This can help you qualify for a lower rate in your capital gains tax.
Donating goods or cash to charity is one deduction you can take advantage of. You may also consider looking at any expensive medical procedures you need to have done to see if they can be counted as deductibles.
How Do I Lower Capital Gains Tax on Property Sale?
As discussed, capital gains tax applies to just about everything you own, both tangible and intangible. Some of these common assets include stocks, bonds, cars, boats, and real estate properties.
In the case of businesses, these may also include expensive investment whose values could depreciate over time.
Depending on the circumstances, however, some assets can be exempt from capital gains tax. Often, this applies to real estate.
One of the biggest assets most people have is their home. Assuming a rising local real estate market rate, selling this may give the homeowner a huge capital gain.
The tax code allows taxpayers to exclude some or all gains from capital gains tax as long as they meet these three requirements:
- In the five-year period prior to the sale, you owned the house for at least two years (you may have rented it for the first three years before buying and owning it for the last two).
- You used the house as your primary residence for a total of two years in the same five-year period.
- You have not excluded said gain from a different home sale in the two-year period prior to the sale.
Assuming you meet these conditions, the IRS grants you a $250,000 tax exemption if you are single. For married couples filing jointly, the IRS provides a $500,000 exemption as well.
Anyone who owns a capital asset – be it tangible assets (real estate properties, cars, etc.) or intangible assets (stocks and bonds) – and sells them is liable to pay capital gains tax, making it a necessary concept all taxpayers need to be familiar with.
Having a basic understanding of this kind of tax equips taxpayers with the rules on its payment, as well as the different deductions he or she could apply to it. If you are still having a hard time with this tax, it is best to consult with experts who can help you out with this matter.
Do you have other questions about capital gains tax we could help you with? Ask us in the comments section below!