Capital gains represent the difference between what investors pay for an asset (plus certain adjustments) and what they sell it for. Capital assets include real estate, stocks, bonds, collectibles, jewelry, antiques, and other items that can increase in value over time. If you don't sell the asset, any increase in its value is an unrealized gain, and won't be taxed, no matter how much the growth is.
However, if you sell the property or other asset for more than its basis, that is a capital gain. If you sell a capital asset for less than its basis, that is a capital loss. Capital losses can offset capital gains and reduce the taxes owed. If you owned the designated property for less than a year, the gain is short-term, and you would owe taxes at your ordinary income rate. That is the same rate you pay on income from wages, interest, and self-employment. It's typically higher than the rate for long-term capital gains. You must hold the asset for a year or more to qualify for the long-term rate.
The rates for federal taxes on long-term capital gains range from zero to twenty percent, depending on income level and filing status. For example, a married couple filing jointly can earn up to $89,250 and not owe federal taxes on a realized capital gain. The rate is 15% for a couple with a taxable income of up to $553,850 and 20% for those with taxable income above that. Thresholds for individual filers are lower.
Nine states have no additional state capital gains tax. These are:
Other states impose capital gains taxes in a wide range from around two percent up to high taxing California, which adds over 13 percent to the tab for capital gains.
Investors may prefer to defer the payment of capital gains taxes when they sell an investment property. One way to accomplish this is by executing a 1031 exchange. In most cases, a 1031 exchange that meets federal regulations, will allow the taxpayer to defer both state and federal capital gains taxes, plus depreciation recapture. However, keep in mind that the rules governing exchanges are strict, and investors must closely adhere to the timelines.
If you exchange property in one state for like-kind property in another, you could owe state capital gains taxes in both states when you eventually sell the replacement property unless you do so using another 1031 exchange. That will be the case if the original asset (relinquished property) is in a state with a clawback statute, including California, Montana, Oregon, and Massachusetts.
A clawback statute means that the state where the asset is located wants to collect the tax it would have been entitled to in the absence of the 1031 exchange. For example, suppose a California resident uses a 1031 exchange to sell a California property and replace it with real estate in Arizona. In that case, the taxpayer will defer both the federal and state capital gains taxes. Later, suppose the taxpayer simply sells the Arizona property without using a 1031 exchange. In that case, they will owe federal capital gains taxes on both properties, plus state taxes in Arizona for selling the replacement, and the deferred taxes that California would have received for the original sale.