Examining the question of when you pay capital gains tax has two components: first, what triggers the requirement to pay the tax, and second, what is the timing of the payment?
What Triggers the Requirement to Pay Tax on a Capital Gain?
A capital gain is an increase in the value of an asset, either an investment or real estate. This results in the asset having a higher worth than the asset's basis. But the simple fact that an asset gains value does not trigger a taxable event. To owe tax, the taxpayer must realize the gain through asset disposition. Suppose you own a stock that consistently increases in value over time. You may feel very wealthy because this asset you purchased for $100 now is worth $10,000. But until you sell the stock and receive $9,900 in appreciation, you have not made a gain. It is possible that the day before you sell the stock, something will happen that results in the stock plunging below the price you paid for it (your basis), and you have no gain, and thus no capital gains tax. Indeed, you have a capital loss that you can use to offset other gains.
Hopefully, though, you sell the asset while it is at the higher level, and you receive the appreciation. Suppose you have owned the asset for less than a year. In that case, the profit (amount of increase over your basis, plus any other out-of-pocket costs and depreciation) will be taxed as a short-term capital gain, generally at the same level as ordinary income. Ordinary income is usually made up of wages, commissions, and interest income, in addition to short-term capital gains.
If you have owned the asset for longer than one year, the gain will typically be subject to the tax rates of a long-term capital gain, which are generally lower than ordinary income rates. Currently, the federal tax rates on long-term capital gains are 0, 15, or 20%, depending on your income. (There are some exceptional circumstances which may result in higher percentages, and the net investment income tax of 3.8% is added if a taxpayer meets certain requirements at a high-income level.) Keep in mind that some states also levy a capital gain tax. Most states tax capital gains and ordinary income at the same rate, but nine states tax long-term capital gains at a lower rate than ordinary income, and nine more have no capital gains tax (or income tax) at all.
When Do I Need To Pay Capital Gains Tax From An Asset Disposition?
The taxpayer reports the capital gain, whether short or long term, on their next tax return. However, if you have a taxable event and the tax is due, you may need to make an estimated tax payment in advance of filing the return. If you fail to do so, you could face penalties and interest, depending on the amount due. The good news about reporting the gain is that you can offset the increase with any losses incurred during the same tax reporting period. Remember that short-term losses are used first to offset short-term gains, but any net losses remaining could be used to offset long-term capital gains (and vice versa).
Always consult your tax advisor about estimated tax payments, appreciation, and reporting issues.
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.
Hypothetical examples shown are for illustrative purposes only.
