Comprehensive guide to Capital Gains Tax
There are many different ways in which the United States government applies taxes to different types of income. For example, there is a type of capital gains, such as profits from a sale or stock which you have held on to for a long time. These gains have different tax rates applied to them and are taxed at a more favorable rate than your salary or interest income. But, the issue stems from the fact that not all capital gains work the same way. When it comes to capital gains tax, it can dramatically vary between long-term and short-term gains. With all that said, it may be quite difficult to understand the whole system. But there’s no reason to worry! With the assistance of IRS tax relief specialists, we’re here to explain everything about Capital Gains Tax. So, let’s dive deep into the numbers and learn how they function!
What exactly are capital gains, and how does the tax apply to them?
Simply put, capital gains are profits a person makes when selling assets in various ways. Most commonly, these assets include businesses, cars, boats, and land. Investment security, such as stocks or bonds, is another type of capital gains. Once you sell one of these assets, a taxable event is triggered since you are gaining capital, as the name implies. In most cases, you have to report your gain or loss on the said asset to the IRS when filing your income taxes. Remember that you can dispose of assets in several ways, including selling, swapping, giving, or transferring ownership of an item. However, whether or not you pay a tax on capital gains depends on a few factors. This is mainly because not all assets incur taxation. As an example, you are unlikely to pay CGT on:
- Your household as it incurs a different kind of tax.
- Giving gifts to your spouse or donating to charity. In most cases, charity is tax deductible.
But on the other hand, you’ll probably have to pay taxes on the following:
- Selling a rental apartment to a different landlord
- Income that stems from one or more business assets
- Selling valuable antiques, jewelry, or art pieces
As you can see, there are different types of taxes. Each is, in effect, based on different circumstances and may have quite a few variations. This is why understanding them properly is a very vital part of functioning in the fast-paced world of today. And, if you’re a business owner, understanding capital gains tax is imperative if you want to operate successfully.
A simple example of a taxable capital gain
When it comes to understanding something as intricate as taxes and percentages, the best way is to give a concrete example. So, let’s do a simple yet effective thought experiment. Let’s say you collect and trade artwork as a hobby or a business. Ten years ago, you paid $5000 for a painting. Now, a decade later, you sell it for $20.000. Since you invested $5000 into it, your total profit is $15.000. In this case, you will effectively owe capital gains tax on the $15.000 you earned, as that is pure profit, and not on the $20.000 sale price. There is one important thing to note here. If you didn’t buy the piece but inherited it instead, you will have to pay tax on the $20.000 sale price, as you had no initial investment.
The difference between short-term and long-term capital gain (and loss)
Generally speaking, capital gains and losses are calculated based on how long you’ve had a specific asset in your possession. This time frame is known as the holding period. Any profit you make from assets that you’ve owned for up to a year is a short-term capital gain. On the other hand, monetary gain from assets that you’ve owned for over a year is a long-term capital gain. In most cases, different tax rates and rules apply to short and long-term gains. If you have to file taxes on stock, expect to pay less. The reason is the fact that the tax rates are lower for long-term capital gains. Keep in mind that capital losses also exist, and they, like gains, too, fall into the two categories. However, we’ll focus on them at a later point.
Short-term capital gains tax rates for 2022
Typically, you don’t benefit from any special rates on short-term gains. These profits are instead usually taxed at the same rates as your regular income. And the tax rate is based on your income and filing status. There are two things to note about short-term capital gains. One is that the holding period starts one day after you’ve acquired the asset, up to and including the day of sale. The other is that the tax rates vary from 10% to 37%, depending on your income and filing status. The different filing statuses are:
- Single individual
- The head of the household
- Married individual filing jointly with a spouse
- Married individual filing separately
For our example, we will use the income of a single individual. Any earnings up to $10.275 come with a 10% tax rate. Earnings over $539.900 bring a 37% tax rate with them. Anything in between separates into categories of 12, 22, 24, 32, and 35 percent tax rates, respectively.
Long-term capital gains tax rates for 2022
As we’ve already established, you can often benefit from reduced rates if you hold your assets for more than one year. Those in the lower tax bracket may not pay anything at all for their capital gains. On the other hand, according to the IRS, high-earning taxpayers can save up to 17% off their ordinary income rate. The filing status is categorized the same way as for short-term gains, with the tax rates being much different. We will, again, use the example of a single individual. Earnings up to $41.675 see no tax at all. Any income between $41.676 and $459.750 receives a 15% tax. Lastly, all earnings above $459.750 see a 20% tax rate. As you can clearly see, the thresholds and the rates are much lower, showing the obvious benefits of holding onto your assets long-term.
Are there any exceptions?
There absolutely are. However, it is important to note that some may help you reduce your tax rates, while others increase them, depending on your situation. One major exception applies to taxes for money-making hobbies. This mainly applies to collectible assets, like antiques, fine art, rare coins, or even vintage wine collections. Usually, there is a 28% tax rate on these collectibles, no matter how long you’ve held onto them. Another exception is the net investment income tax, or NIIT for short. It adds a 3.8% surtax to investment sales made by individuals, estates, and trusts above a set threshold. This surtax usually applies to high-income individuals who, besides their regular income, see a significant amount of gains from investments, interest, and dividend income.
The effect of capital losses on your taxes
As we previously mentioned, different tax rates are applied to short-term and long-term capital gains. However, if your investment ends up losing you money, your tax rates can also change. And even though nobody likes losing money, the good news is that you can use these losses to reduce your taxes. The IRS allows citizens to match up their losses and gains for any given year and thus determine their net capital gain or loss. If you summarize your yearly earnings and end up with a net loss, you can use up to $3000 of it per year to reduce your other taxable incomes. You can carry over any additional losses to future years, with a $3000 limit. Do note that you don’t generate gains or losses in retirement accounts. With that said, you can’t use losses to offset gains in IRAs or 401(K) documents.
When should you pay capital gains tax?
One of the most common questions regarding CGT is when to pay it. Profit is constantly present, so how does one go about reporting it and paying the appropriate tax rates? Even though capital gains tax functions separately, that doesn’t mean that you need to make an isolated tax payment every time you sell something for a profit. Instead, your capital gains go together with your taxable income. The year in which taxable gains occur is the year to which the tax is applicable. Meaning that if you make a profitable sale in the 2022/23 fiscal year, the gains contribute to your 2022/23 total income. If you want to be absolutely sure these numbers are properly filed, we recommend hiring a professional tax consultant.
Ways to reduce your capital gains tax liability
Now that we know what capital gains are and how they function, we can look into ways to reduce the tax rates. It goes without saying that nobody likes paying taxes. And thus, people always look for ways to reduce their tax liability as effectively as possible. There are many popular tax deduction methods however, not all of them can be applied to capital gains tax. Their tax rates function in their own unique way, and thus some deduction methods may not apply here. But, worry not, because we’ll look over a few that do work, which will surely make your life simpler.
Wait until you sell your assets as much as you can
As we established at the very start, capital gains are separated into long-term and short-term categories. And, the tax rates on long-term gains are far more favorable compared to the short-term ones. But, for your asset income to be considered long-term, one year has to pass since you obtained it. With that said, we strongly advise holding on to your assets for as long as you possibly can. Not only will the time duration reduce the tax rates, but the asset itself may be worth more in future years. All things considered, withholding asset sales can be a smart investment for the future.
Don’t be hasty when selling your real estate
The faster you sell your assets, the higher your tax rates will be. This is why holding on to them really pays off. When it comes to selling your home, waiting really is a blessing. Property sales are, of course, seen as monetary gains and, as such, are affected by capital gains tax. However, there are a few exceptions. And one of those exceptions conveniently happens to be among the top tax breaks for homeowners. If you have owned your home for at least five years and lived in it as your main residence for at least two, you’re eligible for a substantial tax reduction. Usually, you can exclude up to $250.000 of capital gains if you’re single. If you and your spouse file your taxes jointly, the number goes up to $500.000. However, you can’t take the full exclusion on multiple home sales within two years.
Invest in tax-deferred or tax-free accounts
Another great way to reduce your tax rates is to invest in the future. If you invest money into 401(K) plans, Roth IRA accounts, or 529 college plans, you can save in taxes significantly. The main reasons why these investments are so favorable are simple. Investments directed toward future plans can grow tax-free. This, in turn, means that you won’t have to pay capital gains tax on any subsequent earnings right away. And in some cases, you won’t have to pay any taxes at all, even when you take money out of these accounts.
If you want to learn more about taxes and tax breaks, Consumer Opinion Guide has a rich database of resources to explore. You can also find tax specialists to consult among a select group of professionals on our website.