Most people are familiar with income taxes and sales taxes. Income taxes are automatically withheld from pay or paid by independent contractors, self-employed individuals and some others based on how much money is earned. Sales taxes, meanwhile, are paid at the point of purchase when we buy retail goods and some services.
But there’s another kind of tax that’s often not as well-understood: capital gains taxes.
Which Assets Qualify for Capital Gains Tax?
Capital gains taxes are owed when an asset, such as investment securities or real estate, is sold for more money than was paid for the asset.
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How Capital Gains Are Computed
A capital gain is computed by subtracting the purchase price of an asset from the selling price. So if you bought a stock for $1,000 and sold it for $2,000, you would realize a capital gain of $1,000. You will owe tax on this $1,000 capital gain during the tax year when you sold the asset.
Put simply: Capital Gain = Selling Price – Purchase Price
Note that tax is only owed on capital gains when they are realized, or sold. If you hold onto this stock instead of selling it, you have what’s termed an unrealized capital gain. No tax would be due on the gain until you sold the asset.
The rate of tax that’s due on capital gains depends on how long you hold the asset. If you hold a stock for one year or longer, your gain will be taxed at the long-term capital gains tax rate. But if you hold a stock for less than one year before selling it, your gain will be taxed at your ordinary income tax rate.
Capital Gains Rates for 2021
Long-term capital gains tax rates are based on adjusted gross income (AGI). The basic capital gains rates are 0%, 15%, and 20%, depending on your taxable income. The income thresholds for the capital gains tax rates are adjusted each year for inflation.
Capital Gains
Tax Rate
Taxable Income
(Single)
Taxable Income
(Married Filing Separate)
Taxable Income
(Head of Household)
Taxable Income
(Married Filing Jointly)
0%
Up to $40,400
Up to $40,400
Up to $54,100
Up to $80,800
15%
$40,401 to $445,850
$40,401 to $250,800
$54,101 to $473,750
$80,801 to $501,600
20%
Over $445,850
Over $250,800
Over $473,750
Over $501,600
Capital gains on a primary dwelling are taxed differently from other real estate, due to a special exclusion. The first $250,000 of your gain on the home sale is excluded from your income for that year, as long as you owned and lived in the home for two years or more out of the last five years. For married couples filing jointly, the exclusion is $500,000.
Avoiding or Minimizing Capital Gains Taxes
There are several strategies you can implement that can help you avoid or minimize capital gains taxes. Here are four.
1. Hold onto taxable assets for the long term.
The easiest way to lower capital gains taxes is to simply hold taxable assets for one year or longer to benefit from the long-term capital gains tax rate. While marginal tax brackets and capital gains tax rates change over time, the maximum tax rate on ordinary income is usually higher than the maximum tax rate on capital gains. Therefore, it usually makes sense from a tax standpoint to try to hold onto taxable assets for at least one year, if possible.
2. Make investments within tax-deferred retirement plans.
When you buy and sell investment securities inside of tax-deferred retirement plans like IRAs and 401k plans, no capital gains tax liability is triggered. Capital gains aren’t taxed until you begin withdrawing funds in retirement, at which time you may be in a lower tax bracket than you are now.
Since retirement account funds are able to grow on a tax-deferred basis, the account balances may grow even more than they would if capital gains taxes were assessed pre-retirement. Roth IRAs and 401k plans take this one step further: Capital gains taxes aren’t assessed even when funds are withdrawn in retirement as long certain rules are followed.
3. Utilize tax-loss harvesting.
This strategy involves selling underperforming investments and booking a loss. You can use these capital losses to offset taxable investment gains and up to $3,000 each year of ordinary income. Unused investment losses each year can be carried forward indefinitely to offset capital gains and ordinary income in future years.
For example, suppose you realized a taxable profit of $5,000 on a stock sale this year. However, you own a stock that has fallen in value by $2,000 and you don’t expect it to recover anytime soon. You could sell this stock, book the $2,000 loss and reduce the taxable gain on the other stock to just $3,000.
It’s important to note that you can buy back the stock you sold at a loss if you wait at least 30 days to do so. If you buy it back sooner than this, the so-called “wash-sale rule” will prohibit you from using the loss to offset the capital gain.
Read More: Guide to Tax-Loss Harvesting
4. Donate appreciated investments to charity.
Investments that have appreciated in value from when you purchased them can be donated to charity. You will receive a charitable donation tax deduction for the fair market value of the investment on the date of the charitable donation and will not pay capital gains tax on the investments donated to the charity.
Read More: Tax-Wise Charitable Giving: Donating Appreciated Assets
Capital Gains on Real Estate
As mentioned above, tax law provides a capital gains tax exclusion of up to $250,000 (or $500,000 for married couples filing jointly) on profits from the sale of a home.
Keep in mind a few rules for this special exclusion:
It only applies to a home if it is your primary residence. It doesn’t apply to rental properties.
You must have lived in the home for at least two of the past five years. However, you don’t need to have lived in the home for two consecutive years.
You can only take advantage of this exclusion once every two years.
To accurately calculate how much you’ll owe, determine your cost basis. Add the sale price plus the cost of home additions and improvements with a useful life of more than one year, along with expenses associated with the purchase and sale of the home. The former include closing costs, title insurance and settlement fees, while the latter include real estate commissions and attorney’s fees. Then, subtract your full cost basis in the home from the sale price to arrive at your taxable profit.
Deducting these costs from the sale price of the home will lower your capital gain on the home sale, which could make a difference if you’re right on the edge of the $250,000/$500,000 exemption threshold.
Rental Real Estate
Tax code section 1031 provides a way to defer the capital gains tax on the profit you make on the sale of a rental property by rolling the proceeds of the sale into a new property. Specific rules must be followed to properly complete the 1031 exchange; you can utilize a qualified 1031 exchange intermediary escrow company for this type of transaction. The capital gains tax will be paid once the new property is sold. Savvy real estate investors may decide to defer the capital gains on rental property indefinitely by continuing to use 1031 exchange transactions for all of their rental property sales.
The Bottom Line
Tax optimization is part of your overall financial plan. You can take a few actions now to get yourself on the right track.
Download 5 Tax Hacks for Investors, an actionable guide to tax optimization with insights from fiduciary financial advisors. The guide is free.
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Personal Capital compensates Brian E. Leyde (“Author”) for providing the content contained in this blog post. The information and content provided herein is general in nature and is for informational purposes only. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking action based on this information. Tax laws and authorities are subject to change, either prospectively or retroactively, and any subsequent change could have a material impact on your situation.
