While capital gains tax is simpler than income tax, we tend to pay less attention to it. However, it is impossible to achieve tax efficiency without a clear understanding of the intricacies of capital gains tax. They may not constitute a big part of your tax bill like income tax, but they are essential nonetheless.
We’ll consider everything you need to know about capital gains tax, including the definition of capital gains and losses, the tax rates on capital gains, special rules on some assets, and simple strategies that can help you achieve tax efficiency.
Let’s get started.
What are Capital Gains?
A capital gain is the difference between the sales price of an asset and its purchase price. These assets include stocks, bonds, mutual funds, real estate properties, and collectibles (precious metals, jewelry, arts, etc.)
Let’s take the example of Mr. James, who bought 100 shares of APPLE (AAPL) for $50,000 two years ago. If he sells those shares today for $90,000, the capital gain on that asset is $40,000 ($90,000-$50,000).
Capital gain does not exist until you sell an asset. If the value of a stock (or any other asset) keeps increasing, there are no capital gains until you sell it.
What are Capital Losses?
Capital losses are at the opposite end of capital gains. A capital loss occurs when the sales price of an asset is less than its purchase price.
Suppose Mr. James sold his APPLE shares for $45,000, his capital loss would be $5,000 ($45,000-$50,000).
Like capital gains, capital losses do not occur until you sell the asset.
What is a Capital Gains Tax?
Uncle Sam is always crouching at the door, waiting for you to record capital gains on your assets. The IRS levies tax on your capital gains any time you sell an asset.
For taxation, there are two types of capital gains: short-term capital gains and long-term capital gains.
Short-term capital gains occur when you have held an asset for a year or less. Once you own the assets for more than a year, the gains on the sale qualify as long-term capital gains.
The IRS treats short-term capital gains as an ordinary/earned income – they add it to your earned income (wages, salaries, etc.) and apply the income tax table.
On the other hand, long-term capital gains are subject to capital gains tax rates.
Tax Rates for Long-term Capital Gains
The tax rates for long-term capital gains range from 0% to 15% to 20%. Below is how these rates apply:
- CGT rate is 0% for income levels between $0 and $39,375.
- CGT rate is 15% for income levels between $39,376 and $434,550.
- CGT rate is 20% for income levels above $434,550
Head of Households
- CGT rate is 0% for income levels between $0 and $52,750
- CGT rate is 15% for income levels between $52,751 and $461,700
- CGT rate is 20% for income levels above $461,700
Married and filing jointly
- CGT rate is 0% for income levels between $0 and $78,750
- CGT rate is 15% for income levels between $78,751 and $488,850
- CGT rate is 20% for income levels above $488,850
Married and filing separately
- CGT rate is 0% for income levels between $0 and $39,375
- CGT rate is 15% for income levels between $39,376 and $244,425
- CGT rate is 20% for income levels above $244,425
Your income levels (taxable income) will determine the CGT rates that apply to your capital gains.
Let’s return to Mr. James’ example. Let’s suppose that Mr. James’ earns $80,000 a year and is a single filer.
In that case, Mr. James will be subject to the 15% CGT rate. For his capital gains of $40,000 on the sale of his APPLE stock, he will pay $6,000 (15% * $40,000) in CGT.
Offsetting Capital Gains Tax with Capital Gains Loss
Capital losses occur when the sales price of your assets is less than the purchase price.
In any tax year, you can offset your capital gains with your capital losses.
You start by offsetting your short-term capital gains with your short-term capital losses. The result is your net short-term capital gain. Then you offset your long-term capital gains with your long-term capital losses. The result is your net long-term capital gain.
If your net short-term capital gain is negative (capital loss exceed capital gain), you can use it to offset your positive net long-term capital gain.
You can also use any excess capital losses to offset income tax up to $1,500 for single filers and $3,000 for joint filers.
How does this work?
Suppose your short-term capital losses exceed your short-term capital gains by $10,000. Also, suppose your net long-term capital gain is $5,000. Consequently, after offsetting your long-term capital gain ($5,000) with your net short-term capital loss ($10,000), you still have $5,000 capital loss unused.
You can use up to $1,500 or $3,000 of the unused capital loss to offset your taxable income.
You can carry the remaining capital loss ($3,500 or $2,000) over to the next tax year.
Example of Offsetting
Let’s assume the following details about Miss Kim, a financial analyst, for the year 2019.
- Sold 100 shares of a stock she bought two years ago at $40,000 for $56,000.
- Sold 1000 shares of a stock she bought three years ago at $100,000 for $90,000
- Sold mutual funds she bought nine months ago at $50,000 for $35,000
- Sold mutual funds she bought six months ago at $70,000 for $74,000
- Annual taxable income is $150,000
- She’s a single filer.
Her short-term capital gains are $4,000 (the mutual funds she held for six months). Her short-term capital gains loss is $15,000 (the mutual funds she held for nine months).
Her net short-term capital loss is $11,000.
On the other hand, she had long-term capital gains of $16,000 (the shares she held for two years) and capital losses of $10,000 (the shares she held for three years.
Her net long-term capital gain is $6,000.
Miss Kim will offset the $6,000 long-term capital gain with the $11,000 short-term capital loss. After this offset, she still has $5,000 capital loss unused.
She can use $1,500 (as a single filer) of the unused capital loss to reduce her taxable income to $148,500 ($150,000-$1,500). Furthermore, she can reserve the remaining $3,500 ($5,000-$1,500) for the next tax years.
Capital Gains Tax on Real Estate
When you sell owner-occupied real estate property, $250,000 of the capital gains ($500,000 for joint filers) is exempt from capital gains tax (provided you have stayed there for at least two years). However, you cannot deduct capital losses on the sale of personal properties.
For investment real estate, the tax authority subtracts the amount by which the property depreciates from the purchase price. This has the effect of increasing the capital gains when you sell the property. There is a 15% flat tax rate on the depreciable amount.
For example, if you purchased an investment real estate for $400,000 and depreciated it by $30,000, the purchase price for CGT calculation is $370,000.
Suppose you sold the real estate for $700,000, the capital gains are $330,000, of which $30,000 is the reapplied amount (depreciation), and $300,000 is the actual capital gain.
The reapplied amount is subject to a flat tax rate of 15%, while the actual capital gains follow the CGT rules above.
Capital Gains Tax on Collectibles
Collectibles include precious metals, jewelry, arts, and antiques. Collectibles are subject to a flat CGT rate of 28%.
The Net Investment Income Tax
Suppose your modified adjusted-gross-income exceeds $200,000 for single filers and heads of household, $125,000 for married couples who file separately, and $250,000 for married couples who file jointly. In that case, you will pay a net investment income tax of 3.8% on your capital gains.
How to Achieve Tax Efficiency with Capital Gains Tax
The first step towards achieving tax efficiency is to target long-term capital gains. For tax purposes, long-term capital gains are cheaper than short-term capital gains.
Ensure you hold your investments for more than a year before selling them to qualify for long-term capital gains tax. This tax advantage is one reason why long-term investing is better than short-term investing.
Try to keep a record of when you purchase an asset so you do not sell just when you can wait for a week to fall into the long-term capital gains bracket. Keeping track of your investments will help you take advantage of lower tax (and less money to Uncle Sam).
It would be best if you also considered waiting until retirement before selling some of your investments. Since your income at retirement will be lower than your income during your working years, you will enjoy a lower CGT rate.
Finally, ensure you keep track of your capital losses and maximize them towards reducing your capital gains and income tax.
Capital Gains Tax constitutes an essential part of your tax liability. Understanding them is the first step towards reducing them and achieving tax efficiency.
Start keeping track of your investments to minimize your capital gains tax and maximize the usefulness of your capital losses. Less money for Uncle Sam is more money for you to spend as you wish.
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