When a taxpayer sells an asset for more than its basis, it’s generally regarded as taxable income. This can be any asset - from a real estate investment property to your car or even your TV. These are considered capital gains, and taxpayers are responsible for accurately reporting this information to the IRS.
When Does It Apply?
Income from capital gains are taxed differently than ordinary income. Your ordinary income tax percentage (earnings from employment, self-employment, interest, dividends, or royalties) is dependent on your tax bracket, while the tax percentage on income from capital gains is dependent on how long the seller held that asset and is realized when it’s sold at a price higher than its basis. However, income from an investment property, such as rent, is taxed as ordinary income.
Not every capital asset qualifies as being taxable, including business inventory and depreciable business property. If a property is being used for personal use, such as your primary residence, you may exclude some or all gain as long as:
- You owned the home for at least two years in the five-year period before the sale.
- The property was used as a primary residence for at least two years in that same five-year period.
- In the two-year period before the sale, you haven’t excluded gain from the sale of another home.
If these conditions are met, $250,000 can be excluded if single and $500,000 if married and filing jointly.
Long-Term vs. Short-Term Capital Gains
The length of ownership is important because it affects how much tax you end up paying on that asset. Long-term capital gains result from assets that are held for more than one year before being disposed of. The tax rate for long-term capital gains is 0%, 15%, or 20%, dependent on your taxable income and filing status. Long-term capital gain tax rates are generally lower than short-term tax rates.
Short-term capital gains result from assets that are held for less than a year before being disposed of. Short-term capital gains are subject to taxation as regular income to one of the seven federal tax brackets with rates ranging from 10% to 37%.
Lowering or Avoiding Capital Gains Tax
There are several strategies to minimize or defer capital gains tax:
- Retirement plans: Investing through retirement plans, such as a 401(k) or IRA, allows you to defer immediate taxes. When money is withdrawn, it’s taxed as ordinary income. With a Roth account, you can withdraw tax-free. Roth accounts are best if you’re in a higher tax bracket after retirement.
- Long-term investments: Holding onto assets for over a year means you can pay the lowest rates on capital gains tax.
- Use capital losses to offset capital gains: If you have a loss on an investment, you can decrease the tax on your gains on other investments. If the loss is greater than your capital gain, you can use up to $3,000 to offset ordinary income for the year. You can carry over the loss to future tax years until it’s drained.
- Know your cost basis: When reporting the sale of an investment to the IRS on your taxes, the method you choose to identify your sold shares can impact how much you owe.
- Consider a 1031 exchange: Under IRS Section 1031, a taxpayer can defer capital gains and income tax liability when exchanging like-kind real property for another within a strict time period. A 1031 exchange follows strict rules and requirements to qualify for tax deferment.
Your income tax liability should be part of your investment strategy, and it’s up to the taxpayer to report any realized gain for tax purposes. A tax professional can assist you in estimating your tax liability on capital gains.
The Investor's Cap Gains Guidebook
Re-invest your capital gains. Defer or Eliminate Taxable Income.