Frequently Asked Questions About Capital Gains

Most Americans will admit that instant gratification is an Achilles’ heel, especially in their personal financial realm. Digital devices increase the ease in which we execute transactions to buy. The Federal Reserve offers proof: credit card debt has entered the stratosphere: it has reached $1.04 trillion and is still on an upward trajectory.

On the flip side, many others are motivated to grow wealth. They actively seek legitimate ways to avoid paying taxes on profits made from selling assets. Instant gratification is just as real for them; they want to enjoy the fruit of their harvest and lock in those gains. Yet selling too soon can trigger a short-term gain, which can be an expensive mistake. Once the ‘sell’ signal is transmitted, there’s no way to rewind time. Before you make that critical decision and sell too soon, hit the pause button and examine potential tax consequences. To help you capitalize on your gains, we have compiled a list of Capital Gains FAQs below. 

What Does Capital Gains Mean?

Capital gain is an increase in the value of any capital asset. This could be real estate, stock, rents, and royalties or an investment that has a higher worth than the basis of the particular asset. Think of capital gains as a profit made by selling a capital asset – if the price collected on the sale surpasses the asset’s adjusted basis. The taxes owed (capital gains tax) on the profit is determined by the date of sale and the adjusted gross income of the taxpayer.

Short Term vs. Long Term Capital Gain

Gains from assets held for less than one year – short-term – will be taxed at an investor’s ordinary income rate. Taxpayers who buy and sell frequently will feel the sting of these higher tax rates, as they take a huge bite out of their profits.

Long-term capital gains apply to assets held for one year and longer. These gains will be taxed at a more favorable rate – one that’s lower than the ordinary income rate – 0%, 15%, or 20%. 

Are Capital Gains Considered Income?

Most everyone is familiar with earned income: wages, salaries, and tips fall into this category.

Money received in various other ways is called unearned income and is not considered compensation. Some of these sources include pension income, capital gains, annuity payments, unemployment, and interest income. While both income streams – earned and unearned - are taxable, the taxes on unearned income may be at a lower rate – for example, taxes on long term capital gains. Short term capital gains, however, will be taxed at your ordinary tax rate.

Are Dividends Capital Gains?

When taxed, dividends can fall into one of two categories – unqualified and qualified dividends. Unqualified dividends, which are typically seen in most common or preferred stocks, are taxed at ordinary federal income tax rates that range from 10% to 37%. Qualified dividends, however, are taxed at the taxpayer’s capital gains rate, which ranges from 0% to 23.8% (including Net Investment Income Tax). 

To qualify for the lower tax rate, a dividend must meet the following criteria: 

1. Paid by a U.S. company or qualifying foreign company
2. Not listed with the IRS as non-qualifying
3. Held by the investor for more than 60 days for common stock and 90 days for preferred stock

Note that dividends paid by real estate investment trusts (REITs), master limited partnerships, employee stock options, and tax-exempt companies are automatically exempt from qualified dividend treatment.

How Do Capital Gains Tax Work?

A capital gain is only realized when a taxpayer sells the asset. The asset may increase significantly in value, but you will not be required to pay capital gains tax once it is sold. Taxpayers may substantially reduce the amount of capital gains taxes by holding the asset for more than one year.

What Is the Capital Gains Rate?

Over the past decades, capital gains rates have fluctuated. In 1913, they were 15%. In 1993, they had nearly doubled, at 29.19%. Nearly 30 years later, the long-term capital gains tax rates have changed again, thanks to the Tax Cuts and Jobs Act (TCJA). Instead of being linked to ordinary income tax brackets, they now have their own distinct brackets.

How much is the Capital Gains Tax?

Long-term capital gains tax rates for the 2020 tax year are depicted in the chart below. Short term capital gains taxes are calculated using the ordinary rate.

What Is Capital Gains Tax on Real Estate? 

Capital gains taxes are only due on the sale of a real estate asset.
Consider this capital gain calculation: a taxpayer purchased an investment property for $500,000 and claimed $100,000 of depreciation over the holding period. The result is a $400,000 adjusted basis. The taxpayer now sells the property for $600,000, creating a capital gain of $200,000. Note that of this $200,000 gain, $100,000 will be taxed as depreciation recapture.

How Much Is Capital Gains Tax On Inherited Property?

Inheriting a Rembrandt or a Picasso would be a wonderful stroke of good luck. Most people, however, will likely only see such works of art in a museum. Inheriting a home from a relative, however, is highly probable. The first thing to remember is to start with the tax basis; that’s the value used to calculate the gain whenever you sell the property.

The IRS has determined that in cases of inheritance, the tax basis is the value upon the decedent’s date of death. For example, if the fair market value of the property is worth $500,000 when the individual passes, that’s the tax basis. It is irrelevant if the original purchase price was $100,000 a quarter of a century ago. Thus, the beneficiary’s tax basis is “stepped-up.” If the inheritor sells the property for $525,000, the capital gains tax will be assessed on only $25,000.

When Is Capital Gains Tax Due?  

The IRS requires that taxpayers report all capital gains on their individual income tax return. If the sale of an asset results in a substantial gain, you may need to make estimated tax payments. This will allow you to cover your tax liability. For reporting capital gains from stocks, bonds, and applicable investments, taxpayers should file 1040 Schedule D, and Form 8949, Sales and Other Dispositions of Capital Assets.