The IRS taxes different types of income at different rates. When it comes to some types of capital gains, they can be taxed at more favorable rates than ordinary income. However, not all capital gains are taxed equally and rates can vary widely.
Not only is it crucial that investors understand capital gains and what they can potentially expect when it’s time to file and pay federal income taxes, but policies surrounding capital gains taxation are always subject to alterations.
What Are Capital Gains?
Capital gains are the profit generated from the sale of an asset. Capital gains only apply to capital assets, such as stocks, bonds, jewelry, coin collections, and real estate property. As long as you hold onto the capital asset, you don’t have to pay taxes on it. In fact, even at death, your heirs don’t have to pay either.
When the property is sold at a profit, this is known as a realized gain. When it’s sold below its adjusted tax basis, it’s a realized loss. When there’s a loss, the investor isn’t required to pay capital gains taxes, and it can be used to offset similar types of capital gains. If losses outweigh gains for that tax year, this is known as a net capital loss and investors can declare up to $3,000 on their tax return to offset other types of income. Anything over that amount can be carried over as a loss for the following year.
How Are Capital Gains Taxed?
When you make a profit, Uncle Sam wants his share. It’s often said that capital gains are taxed more favorably, but this isn’t always the case. Capital gains tax rates depend on how long you held the asset before its sale, as well as your income bracket.
Short-Term Versus Long-Term Capital Gains
Capital gains can be divided into two categories: short-term and long-term.
- Short-term investments held for a year or less are known as short-term and are taxed as ordinary income up to 37%, depending on your tax bracket. Individual states also tax short-term investments the same as the federal government.
- Long-term investments are treated more favorably, which are held for longer than a year before being sold. State long-term capital gains tax rates are generally lower than federal rates and are the same as state income tax rates. Federal rates can be broken down into three brackets for a 2021 single-filer:
- 0% - Up to $40,400
- 15% - $40,401 to $445,850
- 20% - Over $445,850
These numbers change, and current rates are historically low. Since the capital gains tax was introduced, rates higher than 20% were more commonplace. Even now, there are proposals by the current administration to raise taxes on long-term capital gains for those earning $1 million or more to 39.6%. If you add that to the existing 3.8% net investment income tax on higher-income investors, the federal tax rate would rise to 43.4%.
There are a few rules and exceptions when it comes to how capital gains are taxed. Here are a few of them:
- If you sell a primary residence and owned and used the home for at least two of the last five years, you don’t have to pay capital gains taxes on the first $250,000 of gain from the sale. For married couples, that exclusion is $500,000.
- Long-term capital gains on collectibles are taxed at 28%.
- Capital losses from the sale of personal property aren’t deductible.
- High-income investors may need to pay an investment surtax, which is an additional 3.8%, on all investment income.
- If you inherit an asset, the holding period is considered long-term.
Calculating Capital Gains
To calculate capital gains, you’ll first need to determine your asset’s basis, which is the price you paid plus taxes and additional funds you reinvested back into the asset. Your total gain is calculated by subtracting the sales proceeds from the adjusted basis. If the number is positive, then that is your gain — however, if the number is negative, you may be able to use that loss to offset any gains.
Here’s an example:
Let’s say you realized $250,000 from the sale of real property but the year before, you lost $75,000 from assets held longer than a year, your net gain would be $175,000.
These are just general calculations, and it’s highly advised that you seek help from a tax professional when calculating your capital gains and what you owe in taxes.
Ways To Offset Capital Gains
Investors use several strategies to offset capital gains. Here are a few strategies to potentially ease your tax burden:
Wait longer than a year before you sell. If you wait longer than a year before selling your asset, you can possibly benefit from more favorable tax rates. All it takes is some careful planning.
Tax loss harvesting is selling assets at a loss to offset capital gains tax liability. If losses exceed gains for that year, investors can use up to $3,000 a year to offset ordinary income on income taxes.
Sell when your income is lower. Have you or your spouse recently quit a job? Are you about to retire? Waiting and selling during a year when your income is lower will put you into a lower tax bracket.
Reduce your taxable income. If you’re selling short-term assets, you can minimize your short-term capital gains tax rate by reducing your taxable income. This can be done by making contributions to a traditional IRA or 401(k) or by taking advantage of credits and deductions when filing your tax return, such as investing in municipal bonds. Interest from municipal bonds is exempt from federal and some state income taxes.
Ways To Defer Capital Gains
Some IRS codes allow taxpayers to defer or even eliminate capital gains tax liability. Here are several common capital gains deferment methods often used by real estate investors.
Under Section 1031 of the U.S. Internal Revenue Code, taxpayers can defer capital gains on the exchange of certain types of real property. The biggest benefit of the 1031 exchange is the ability to defer your capital gains taxes — indefinitely — so long as you continue to reinvest capital back into real property.
A 1031 exchange is a strategy that allows investors to sell investment or business properties and invest the proceeds into “like-kind” replacement properties. Basically, you can “swap until you drop,” and your beneficiaries can receive a one-time step-up in basis that could potentially eliminate the rolled-over tax liabilities.
If you sell an asset that was purchased through a 1031 exchange without reinvesting those proceeds into a like-kind property, you could be hit with a massive tax bill from that property as well as any taxes owed through previous 1031 exchanges.
Step-Up In Basis
When a taxpayer leaves an asset to a beneficiary upon death, the tax basis of that beneficiary is “stepped-up” to the fair market value of the asset at the time of inheritance. A step-up in basis eliminates the capital gain that occurred between the original purchase price and the beneficiary’s acquisition.
For example, let’s say you bought a property 10 years ago for $150,000 and it was worth $300,000 at the time of your death. Your daughter is receiving the property on a “stepped-up” basis at the time of your death, which is $300,000. Thus, no capital gains tax liability.
Invest In Opportunity Zones
The 2017 Tax Cuts and Jobs Act offered a new incentive for investors, called Qualified Opportunity Zones (QOZs). Through the Qualified Opportunity Zones program, the federal government has designated QOZs, which are economically distressed communities, where new investments may be eligible for preferential tax treatment.
Accredited investors can invest in these communities through a Qualified Opportunity Fund and the tax benefits depend on how long investors hold onto the QOF investment. Here are the holding requirements and their tax benefits:
- Deferral of capital gains taxes: Existing assets with accrued capital gains can be placed into a QOF and be deferred until the end of 2026 or when the asset is sold.
- Step-up in basis: For capital gains placed in a QOF for at least 5 years, the basis on the original investment increases by 10% and can increase by 15% if it’s more than 7 years.
- Exclusion of taxable income on new gains: Investors pay no capital gains tax accumulated through their investment in the QOF if held for at least 10 years.
If you sell an investment for more than the cost basis, there’s a capital gain, and you could owe taxes on that gain. Every investor should familiarize themselves with capital gains and their tax burden, not only to stay out of hot water when it’s time to file tax returns but also to reduce or potentially eliminate capital gains tax liability.
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. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. All real estate investments have the potential to lose value during the life of the investment. The income stream and the 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 the transaction may impact investor’s returns and may outweigh the tax benefits. The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time. 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.