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. To illustrate, an investor can own shares that appreciate every year, but the investor does not incur a capital gains tax on the shares until he sells them.
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 the United States, individuals and corporations are subject to capital gains taxes on their annual net capital gains.
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 winning investment. As a result, the taxpayer has 0 net capital gains, meaning he does not incur any capital gains tax.
Capital Gains Tax Rates
The Internal Revenue Service (IRS) taxes capital gains at different rates than other types of income. As of 2015, most taxpayers pay a 0 to 15% tax rate on their capital gains, and the top rate is 20%; however, certain net capital gains face a 25 to 28% tax rate.
Capital Losses and Capital Gains Tax
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 2015, 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 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 following years.
Capital Gains Tax on Personal Assets
In most cases, tax filers must report capital gains for the sale of any asset, including personal assets; however, as of 2015, the IRS allows an individual filer to exclude up to $250,000 in capital gains on his primary residence, subject to ownership and use tests. 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.