Capital Gains Tax

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What is a 'Capital Gains Tax'

A capital gains tax is a type of tax levied on capital gains, profits an investor realizes when he sells a capital asset for a price that is higher than the purchase price. Capital gains taxes are only triggered when an asset is realized, not while it is held by an investor. That means he can own stock shares, for example, that appreciate every year, but does not owe a capital gains tax on the shares until he sells them, no matter how long they're held.

BREAKING DOWN 'Capital Gains Tax'

Most countries' tax laws provide for some form of capital gains taxes on investors' gains, although laws vary from country to country. In Canada, for example, residents pay half of their marginal tax rate on capital gains. In the United States, individuals and corporations are subject to capital gains taxes each year on their annual net capital gains. Capital gains taxes apply to anyone who sells an asset for profit – unless that person sells and buys assets for a living, like a day trader. In that case, profits are taxed as business income, not capital gains.

Capital Gains Tax Rates

The Internal Revenue Service (IRS) taxes long-term capital gains (that is, on assets held more than a year) at different rates than other types of income. Under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) passed by Congress in May 2006, U.S. taxpayers in the two lowest tax brackets (which account for about two-thirds of all individual tax returns) pay no capital gains taxes. Those in the 25%-and-higher tax brackets pay a 15% rate on their capital gains; those in the top 39.6% bracket pay 20%. However, certain net capital gains are subject to a 25% to 28% tax rate, if they are from depreciated real estate or from collectibles.

The capital gains tax rate for short-term capital gains (on assets held under a year) is usually the same as the tax rate on earned income or other types of ordinary income. The same rules apply for long and short-term losses respectively.

Though they can both represent a profit, capital gains, which result from selling an asset, aren't the same as dividends paid by an asset. In the U.S., dividends are taxed as ordinary income, for taxpayers in 15% and higher tax brackets.

Net Capital Gains

Net capital gains refers to the total amount of capital gains minus any capital losses. This means if an investor sells two stocks during the year, one for a profit and an equal one for a loss, the amount of the capital loss on the losing investment counteracts the capital gain from the profitable investment. As a result, the taxpayer has zero net capital gains, meaning he does not incur any capital gains tax.

Investors who have both long and short term gains and losses can easily compute their final net gain. First, it is necessary to add all like-kind gains and losses together. For example, if an investor has four short-term gains, then these amounts must be added together to get a final total of all short-term gains. The same thing must be done with long-term gains and long and short-term losses. Then, when each type of gain and loss has been aggregated into four separate totals, the short-term gains are netted against the short-term losses to produce a net short-term gain or loss. The same thing is done with the long-term gains and losses. Then, these two numbers are netted against each other to produce a final net number that is reported on the return.

Capital Gains Tax on Personal Assets

In most cases, tax filers must report capital gains for the sale of any security or asset, including personal assets; however, as of 2017, the IRS allows an individual filer to exclude up to $250,000 in capital gain on his primary residence, subject to ownership and use tests (like having sold another home in the last two years, and has owned and lived in the house for the last two years). Married couples may exclude up to $500,000. Capital losses from the sale of personal property, such as a home, are not deductible.

For example, if a single taxpayer who purchased a house for $200,000 later sells his house for $500,000, he has a $300,000 capital gain. After excluding $250,000, he must report a capital gain of $50,000, which is the amount subject to the capital gains tax. This capital gains calculation is simplified since in most cases, significant repairs and improvements are also included in the base cost of the house, thus reducing the capital gain.

Capital Losses and Capital Gains Tax

The capital gains tax effectively reduces the overall return that is generated on the investment, of course. But there is a legitimate way that some investors can use to reduce or even eliminate their net capital gains taxes for the year. A taxpayer can use capital losses to offset capital gains and effectively lower his capital gains tax, and if his losses exceed his gains, as of 2017 he may claim a loss of up to $3,000 against his income. Losses roll over, however, and the taxpayer may claim any excess loss against future income to reduce his tax liability in future years.

For example, if an investor has a realized gain of $5,000 from the sale of some securities and incurs a loss of $20,000 from selling other shares, he can reduce his capital gain for tax purposes to $0 using some of the loss amount. The remaining capital loss of $15,000 can be used to offset his income. So if his original income in any given year is $50,000, he can report $50,000 minus a maximum claim of $3,000 (i.e. $47,000) as income to reduce his income tax expenditure. He still has $12,000 of capital losses. Fortunately, capital losses can be rolled forward to subsequent years, which means the $12,000 can be used to reduce any income in the future.

Capital Gains Tax Strategies

Taxpayers who understand the rules for netting gains and losses can generate additional losses to net against the taxable gains in their portfolios as long as they obey the wash sale rule.

Say Jerry has a net short-term capital gain of $800, a short-term capital loss of $2,350, a long-term capital gain of $3,800 and a long-term capital loss of $1,475. Jerry will have a net short-term capital loss of $1,550 ($2,350 - $800) and a net long-term capital gain of $2,325 ($3,800 - $1,475). He will then net his short-term loss against his long-term gain to arrive at a final total net long-term gain of $775 ($2,325 - $1,550). This is the amount that he must report on his tax return.

However, if Jerry had taken stock of all of these gains and losses before the end of the filing year, he might have been able to reduce or eliminate his taxable gain by selling another holding that was trading at a loss. For example, if he owned another stock that had dropped in value by half, he could have sold it to realize a deductible loss that he could use to net against his gain. He could buy the stock back after 30 days in order to satisfy the IRS wash sale rule, which mandates that taxpayers must wait at least 30 days before buying back the same security that they sold for the purpose of creating a loss.

So if Jerry owns shares that are now trading for $1,500 less than the price he paid for them, he can sell them before the end of the year and use the loss that is generated to cancel out his gain. He can even deduct the excess amount against other forms of income on his taxes. As mentioned above, there is a $3,000 limit on net losses each year, but any excess amount can be deducted the following year.

Capital Gains Tax and Retirement

It might behoove investors who are near retirement to wait until they actually do stop working to sell profitable assets. If retirement puts them in a lower tax bracket, their capital gains tax bill might be lessened; if it puts  them into the 15% tax bracket, they will avoid having to pay any capital gains tax at all. But if they're already in one of the "no-pay" brackets, there's a key factor to keep in mind: If the capital gain is large enough, it could push them out of the 15% tax bracket and into a higher one – and cause them to incur a tax bill on the gains, after all.