What Exactly Are Capital Gains Taxes?
Investments fluctuate in value for many reasons. When they appreciate—rise in value—they will not incur taxes while still being held, referred to as unrealized capital gains. However, when investors sell their assets, the appreciation (profit) is realized, incurring capital gains taxes. How much the profit or loss affects the taxes due is contingent on how long investors hold on to the assets.
Profits, Losses, And Taxes
Online trading has increased the ease of buying and selling investments. But investors who hold their assets for less than a year should be mindful that higher tax rates apply to this length of investment. Short-term capital gains and dividends are taxed in the same federal income tax bracket as ordinary and earned income. (If these gains push the seller into a higher tax bracket, some exceptions apply.)
Conversely, investments held longer before being sold incur long-term capital gains. Capital losses incurred in the same year offset the taxable amount. A net capital gain—the total gains minus losses as a positive amount—is the amount taxed. So an investor who sold two assets for a $2,000 loss and a $5,000 gain would pay taxes on the $3,000 positive difference. Depending on the seller’s tax bracket and filing status, the 2020 federal tax rates for long-term net capital gains were 0%, 15%, or 20%.
Investors can carry over any excess capital loss to the following year’s taxes. However, selling and rebuying investments (or “substantially identical” stock or securities) within 30 days will result in a wash sale. In most cases, losses from a wash sale are not deductible. This rule prevents an artificial inflation of losses.
Exceptions
The federal government taxes capital gains on some asset categories by a different standard.
Net Investment Income Tax
One of these exceptions is the Net Investment Income Tax (NIIT). The NIIT is a 3.8% additional tax for realized investment gains over statutory threshold amounts based on filing status. So a couple “married filing jointly” exceeding the threshold of $250,000 of modified adjusted gross income owe this additional tax, for example. The tax can also apply to trusts and estates. Residency, particularly non-resident aliens and dual-resident individuals, may not be subject to NIIT.
Collectibles
Collectibles gains, irrespective of income tax bracket, are taxed at 28%. Meaning someone selling off their silver, art, or jewelry, for example, would owe 28% on any net gain from the sale. And the IRS is the final authority on what is considered a collectible under “any other tangible property” for tax purposes.
Calculating the net gain is also more complicated than usual in this category, considering different offsets apply. One way to minimize the impact of the taxes is to spread the sale out over multiple years. For example, someone selling off their silver could sell some in December and January, dividing the taxes across two tax years.
Real Estate
Capital gains on real estate differ depending on whether the property is an investment or an owner-occupied home. When a homeowner sells their primary residence, capital gains taxes assessments exclude a set amount based on the seller’s filing status.
An individual seller excludes $250,000 of the capital gains from the sale from taxable income. So if the seller bought a primary home for $100,000 and sold it for $250,000, there’d be no capital gains tax on the $150,000 profit. However, if it sold for $400,000, the seller would owe capital gains tax on the $50,000 over the excluded amount. While a couple filing married jointly excludes $500,000, they also both have to meet the residency requirement.
The residency requirement is that owners must reside in the home for a total of 24 months out of the previous five-year period. Those months do not have to be consecutive, and vacations or short absences for other reasons are still considered residency. There are exceptions to the residency rule for those who become incapacitated and have to spend time in a care facility or for those who are members of military service on official extended duty.
Investment real estate, on the other hand, is taxed differently. Depreciation deductions can count against the income. This deprecation offsets the original purchase price, which can be helpful while the property is owned and depreciating. But it can increase the taxable capital gain when it’s sold, by widening the gap between the sale price and the property’s value after deductions.
State Taxes and Legal Reduction of Capital Gains Taxes
States may have their own taxes on capital gains. States that lack an income tax will also lack a capital gains tax because capital gains are officially considered income.
Carry-over capital losses offset capital gains. Investment cost-basis increases due to qualifying expenses also offer reductions. Investors may also find tax advantages in Roth IRA and 401(k) retirement plans. Tax professionals or accountants will have further advice on legally lessening capital gains taxes.