Capital gains are a complex topic governed by an array of rules and exceptions. Knowing how to navigate the protocols and options is vital for investors seeking to manage their taxes. Capital gains are the increase in value of a capital asset, which can be sorted into short-term and long-term.
Keep in mind that investors don’t realize any gain until they sell the asset. For example, if you own real estate with a higher value than your adjusted basis, you have an unrealized gain. When you sell the property, you realize the gain. Also note that there is a difference between a realized gain and a recognized gain, which is the amount of gain on which you pay taxes.
When do I pay capital gains taxes?
Capital gains taxes are typically required when you sell an asset for more than the basis. For example, if you buy stock for $50 per share and the stock's selling price increases to $100 per share, you have an unrealized gain and don't owe any taxes. However, if you then decide to sell the shares, the increase (appreciation) of $50 per share is a realized gain, and you will owe capital gains taxes.
If you hold the stock for less than a year, the gains are considered short-term, and you will owe taxes at the same rate you pay on ordinary income. However, if you held the shares for more than a year, you would pay the long-term capital gains tax rate, which is lower. The same scenario applies to selling real estate. The gain is the difference between the adjusted basis (what you paid plus any acquisition costs) and the sales price.
Do I pay capital gains taxes on capital assets I inherit?
The concept of gains being "forgiven at death" stems from the rules about inheritance. The basis receives a “step-up” to the current market value if you inherit a capital asset. For example, suppose the person who bequeaths the asset to you paid $100,000 for a small office building ten years ago, and you inherit it. If the building is now worth $200,000, that is a gain of $100,000. Because you inherit the asset at the current market value of $200,000, you won’t have to pay capital gains taxes on it if you decide to sell. However, if you hold onto the property for two more years and sell it when it is valued at $225,000, you will then owe capital gains taxes on the recent $25,000 appreciation.
What happens if the asset is in a retirement account?
Assets in retirement accounts like IRAs, 401(k) funds, pensions, and tax-deferred annuities do not receive a step-up in basis when inherited. Since these holdings often receive tax advantages during the grantor’s accumulation, they don’t get the same treatment upon the owner’s death.
Isn’t there a threat to the step-up treatment?
Tax policy in the U.S. is constantly evolving as the federal and state governments seek methods of acquiring revenue to fund operations while distributing the tax burden fairly. As a result, Congress periodically considers proposals to alter the rules, including those related to inheritance and basis. Recently, President Biden proposed repealing the step-up for assets over $1 million for single filers, but Congress dropped the provision.
The Tax Reform Act of 1976 was the most recent successful effort to repeal the step-up rules, but Congress repealed the change before it took effect. Changes like this are often "on the table," but so far, fail to gain traction.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.