Capital gains taxes are assessments levied on the gain from selling capital assets. The amount subject to tax is the difference between the adjusted basis and the sales price. For example, suppose you buy stock for $100 and sell it for $200. If you paid a $5 commission when you purchased it, you add that cost into the adjusted basis, and the net capital gain is $95.
However, the tax rate on that gain is also affected by how long you have owned the asset. If you bought the stock less than a year ago, the increase is short-term and taxed at the same rate as your ordinary income. If you purchased the stock more than a year before selling it, the gain is long-term and taxed at the lower long-term capital gains rate.
Short and long-term capital gains rates differ.
The difference between short-term and long-term capital gains can be significant, depending on the investor’s tax status. For example, the top tax rate in 2023 for ordinary income (from wages and other earnings, plus short-term capital gains) can reach 37 percent for amounts over $693,751 for married couples filing jointly. The top rate kicks in at $578,176 for those filing individually. In contrast, the highest tax rate for long-term capital gains is 20 percent.
There is a substantial difference, as illustrated using a taxable gain of $1,000 for a taxpayer in the highest bracket. The short-term capital gain will owe $370 in taxes, almost double the $200 that would be due if the gain is classified as long-term.
How do I calculate the adjusted basis for a capital gain?
For some capital assets, determining the basis is straightforward, as with the stock example. However, when the asset is property, it can be more complex. The adjusted basis is the purchase price, plus any acquisition costs, plus the cost of any capital improvements, minus any depreciation taken during ownership and any previously deferred capital gains.
Suppose you buy property for $200,000. Add $5,000 for closing costs and $20,000 for improvements for a total basis of $225,000. Then, subtract $8,000 in depreciation claimed while you owned it and $50,000 deferred from a prior 1031 exchange to arrive at an adjusted basis of $167,000. If, after more than a year, you sell that property for $250,000, the gain is $83,000. That is the amount on which you would owe capital gains taxes.
One significant exception to the requirement to pay capital gains taxes is when you sell your primary residence. Since your primary residence is your home, it is not an investment property, and in most cases, you won’t have to pay taxes on the appreciation when you sell it. If you own more than one home, only one at a time is a primary residence, and you must meet the requirements to use the exemption. The most important rule is that you must have lived in the home for at least two of the last five years. The exclusion is limited to $250,000 for a single filer and $500,000 for a couple filing jointly.
How can I defer paying capital gains taxes?
If you sell capital assets like stocks, artwork, precious coins, or collectibles, there is no deferral available for the capital gains taxes you owe. However, if you sell an investment property, you can execute a 1031 exchange to defer the taxes due. The transaction is regulated by the IRS and subject to strict timelines, plus the need for a neutral administrator (called a Qualified Intermediary) to oversee the process. It's complex but can enable investors to leverage their proceeds for reinvestment in another property rather than paying a significant tax bill.
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.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
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.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.
