What is Capital Gains Tax?
Capital gains tax is a tax levied on capital gains, which are profits from the sale of specific types of assets, including stocks, bonds, precious metals and real estate. This tax is calculated on the profit – or positive difference – between the sale price and the original purchase price of the asset.
Most countries' tax laws, though not all, 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, as a day trader does. In that case, profits are taxed as business income, not as capital gains.
Capital Gains Tax
How Capital Gains Tax Works
Capital gains taxes are only triggered when an asset is realized, or sold, not while it is held by an investor. That means someone can own stock shares, for example, that appreciate every year but will not owe a capital gains tax on the shares until they are sold, no matter how long they're held.
Net Capital Gains
The value of an asset doesn't necessarily increase, of course. When an asset decreases in value, it is called a capital loss, which, similar to a capital gain, is realized when the asset is sold. With a capital loss, the sale price is lower than the original purchase price.
The term "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 or she does not incur any capital gains tax.
Long-Term vs. Short-Term Capital Gains
A long-term capital gain refers to the gain an investor realizes on an asset that has been held for longer than 12 months before it is sold. A short-term capital gain is the gain realized on an asset that's held for less than 12 months. The same rules apply for long- and short-term losses, too.
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. If an investor has four short-term gains, for example, 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 tax return.
Capital Gains Tax Rates
The Internal Revenue Service (IRS) taxes all capital gains, but has different rates for long-term vs. short-term gains.
[Important: In the past, long-term capital gains tax rates were based on taxpayers' tax brackets. Now they are based on income thresholds.]
Long-Term Capital Gains Rates
In the past the rate that U.S. taxpayers paid on long-term capital gains was based on their tax bracket, with the two lowest tax brackets between 10% and 15% (which account for about two-thirds of all individual tax returns) paying no capital gains taxes, while those in the top bracket paid 20%.
Now, due to the Tax Cuts and Jobs Act, the long-term capital gains rates are based on income thresholds. For 2019 the rate for single filers is 0% for those who make up to $39,375, 15% for those who make between $39,376 and $434,550 and 20% for those who make $434,551 or more. For taxpayers who are married filing jointly, the rate is 0% for those who make up to $78,750, 15% for couples making $78,751 to $488,850 and 20% for those who earn $488,851 or more. However, certain net capital gains are subject to a 25% to 28% tax rate, if they are from depreciated real estate or from collectibles and art.
Short-Term Capital Gains Rates
Capital gains, which result from selling an asset, aren't the same as dividends paid by an asset, but they both can represent a profit. In the U.S., dividends are taxed as ordinary income, for taxpayers in 15% and higher tax brackets.
Capital Gains Tax Strategies
The capital gains tax effectively reduces the overall return generated by the investment, of course. But there is a legitimate way for some investors to reduce or even eliminate their net capital gains taxes for the year.
How to Use Capital Losses to Offset Capital Gains
Taxpayers can use capital losses to offset capital gains and effectively lower their capital gains tax. If their losses exceed their gains, as of 2017 they may claim a loss of up to $3,000 against their income. Losses roll over, however, and taxpayers may claim any excess loss against future income to reduce their tax liability in future years.
If, for example, 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, the investor can reduce their 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 their income. So if the investor's original income in any given year is $50,000, they can report $50,000 minus a maximum claim of $3,000 ($47,000) as income to reduce their income tax. The investor 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.
How to Generate Additional Capital Losses to Offset Capital Gains
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. If he owned another stock that had dropped in value by half, for example, 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.
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.
Special Considerations for Capital Gains Tax
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 a primary residence, subject to ownership and use tests (like not having claimed the exclusion on another home in the previous two years, and having owned and lived in the house for the past 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.
If, for example, 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. In most cases, significant repairs and improvements are also included in the base cost of the house, thus reducing the capital gain even more.
Capital Gains Tax and Retirement
It might behoove investors who are near retirement to wait until they actually stop working to sell profitable assets. If their retirement income is low enough, their capital gains tax bill might be reduced or they may be able to 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 increase their income to a level where it could cause them to incur a tax bill on the gains, after all.
- Capital gains tax is only paid on realized gains after the asset is sold.
- Capital gains treatment only applies to “capital assets” such as stocks, bonds, jewelry, coin collections and real estate property.
- The IRS taxes all capital gains, but has different rates for long-term gains vs. short-term gains .
- Taxpayers can use strategies to offset capital gains with capital losses in order to lower their capital gains taxes.
- Capital losses can be rolled forward to subsequent years to reduce any income in the future and lower a taxpayer's tax burden.
- Investors who are near retirement should plan carefully when selling profitable assets to make sure the capital gains they realize don't make them incur higher taxes.