Capital Gains Tax: What It Is, How It Works, and Current Rates

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Capital Gains Tax: What It Is, How It Works, and Current Rates
2022 Tax Rates for Long-Term Capital Gains
Filing Status0%15%20%
SingleUp to $41,675$41,675 to $459,750Over $459,750
Head of householdUp to $55,800$55,800 to $488,500Over $488,500
Married filing jointly and surviving spouseUp to $83,350$83,350 to $517,200Over $517,200
Married filing separatelyUp to $41,675$41,675 to $258,600Over $258,600

As seen in the table, the tax rates on long-term capital gains are consistent with the trend of capital gains being taxed at lower rates than individual income.

Special Capital Gains Rates and Exceptions

Some asset classes get different capital-gains tax treatment than others.

Collectibles

Gains on collectibles, such as art, antiques, jewelry, precious metals, and stamp collections, are taxed at a rate of 28% regardless of income. Even if you are in a lower tax band than 28%, you will be taxed at the higher rate. If you are in a higher tax band, your capital gains taxes will be restricted to the 28% rate.

Owner-Occupied Real Estate

If you sell your primary house, a separate criterion applies to real estate capital gains. This is how it works: Individual capital gains on the sale of a property are exempt from taxation up to $250,000 ($500,000 for married couples filing jointly).

This applies if the seller has owned and resided in the house for at least two years.

However, capital losses from the sale of personal property, such as a house, are not deducted against profits, unlike in certain other investments.

Here’s how it would work: A single taxpayer who buys a property for $200,000 and sells it for $500,000 makes a $300,000 profit on the transaction. Following the application of the $250,000 exemption, this individual must declare a capital gain of $50,000, which is subject to capital gains tax.

In most circumstances, the expenses of substantial house repairs and renovations may be added to the purchase price, decreasing the amount of taxable capital gain.

Investment Real Estate

Real estate investors are often permitted to subtract depreciation from their revenue to represent the property’s gradual degradation as it matures. (This is a degradation in the physical condition of the residence and is unrelated to its changing market worth.)

Depreciation deduction decreases the amount you’re regarded to have spent for the property in the first place. If you sell the property, this might raise your taxable capital gain. Because the difference between the property’s valuation after deductions and its selling price will be larger.

Example of Depreciation Deduction

For example, if you purchased $100,000 for a building and are permitted to deduct $5,000 in depreciation, you will be taxed as if you spent $95,000. The $5,000 is then viewed as recapturing those depreciation deductions when the real estate is sold.

The recovered sum is subject to a 25% tax rate. So, if the individual later sold the building for $110,000, the total capital gains would be $15,000. Then, $5,000 of the selling price would be viewed as a recapture of the tax deduction. The reclaimed sum is taxed at a rate of 25%. Depending on the investor’s income, the remaining $10,000 in capital gain would be taxed at 0%, 15%, or 20%.

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Investment Exceptions

If you earn a lot of money, you may be liable to additional tax called the net investment income tax.

If your modified adjusted gross income or MAGI (rather than your taxable income) reaches certain thresholds, you will be subject to an extra 3.8% tax on your investment income, including capital gains.

These are $250,000 if married and filing jointly or a surviving spouse; $200,000 if single or head of household; and $125,000 if married and filing separately.

Calculating Your Capital Gains

To determine your taxable profits for the year, subtract capital losses from capital gains.

If you’ve had capital gains and losses on both short-term and long-term investments, the computation gets a bit more complicated.

First, differentiate short-term profits and losses from long-term gains and losses. To get at a total short-term gain, all short-term profits must be reconciled. The short-term losses are then summed. Finally, long-term profits and losses are computed.

The short-term profits are subtracted from the short-term losses to determine the net short-term gain or loss. The same is true for long-term profits and losses.

Capital Gains Calculator

Most people calculate their taxes (or have a professional do it for them) utilizing software that does the calculations automatically. However, you may utilize a capital gains calculator to obtain an estimate of how much you would pay on a projected or actualized sale.

Capital Gains Tax Strategies

The capital gains tax essentially affects the investment’s total return. However, some investors may legally decrease or even eliminate their net capital gains taxes for the year.

The most basic strategy is to retain assets for more than a year before selling them. This is prudent since the tax on long-term capital gains is often lower than on short-term profits.

1. Use Your Capital Losses

Capital losses will balance capital profits, lowering capital gains tax for the year. But what if the losses outnumber the gains?

There are two possibilities. If your losses exceed your earnings by up to $3,000, you may deduct that amount from your income. Because the loss is carried forward, any excess loss that is not utilised in the current year may be deducted from income to decrease your tax obligation in future years.

For example, suppose an investor makes $5,000 from the sale of certain stocks but loses $20,000 from the sale of others. The capital loss may be used to offset the $5,000 gain in taxes. The remaining capital loss of $15,000 may then be utilized to offset income and hence tax.

So, if an investor earns $50,000 per year, he or she may report $50,000 less a maximum yearly claim of $3,000. This amounts to $47,000 in taxable income.

The investor still has $12,000 in capital losses and may deduct the maximum of $3,000 annually for the next four years.

2. Don’t Break the Wash-Sale Rule

Be wary of selling stock shares at a loss to get a tax benefit and then repurchasing the same investment. If you accomplish this in 30 days or fewer, you will violate the IRS’s wash-sale rule for this series of transactions.

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Capital gains of any sort must be reported on a Schedule D form.

Capital losses may be carried forward to future years to decrease future income and minimize the taxpayer’s tax burden.

3. Use Tax-Advantaged Retirement Plans

One of the numerous benefits of participating in a retirement plan such as a 401(k) or an IRA is that your assets increase year after year without being subject to capital gains tax. In other words, you may buy and sell inside a retirement plan without losing a portion to Uncle Sam every year.

Most plans do not require members to pay tax on money until they are withdrawn. Regardless of the underlying investment, withdrawals are taxed as ordinary income.

The Roth IRA or Roth 401(k) is an exception to this rule, since income taxes are collected when funds are deposited into the account, making qualifying withdrawals tax-free.

4. Cash in After Retiring

Consider deferring the sale of lucrative assets until you have officially retired. If your retirement income is smaller, your capital gains tax obligation may be decreased. You may even be able to avoid paying capital gains tax entirely.

In short, consider the implications of paying taxes while working rather than after you retire. Realizing the gain sooner may lead you to fall out of a low- or no-pay bracket, resulting in a tax charge on the profits.

5. Watch Your Holding Periods

Remember that an asset must be sold more than a year to the day after it was bought in order to qualify for long-term capital gain treatment. If you are selling a security that you purchased around a year ago, be careful to confirm the exact transaction date before you sell. By waiting a few days, you may be able to prevent its classification as a short-term capital gain.

Of course, timing manipulations are more important in big deals than in minor trades. The same is true if you are in a higher tax bracket as opposed to a lower one.

6. Pick Your Basis

When purchasing and selling shares in the same firm or mutual fund at various dates, most investors utilize the first-in, first-out (FIFO) technique to assess the cost basis.

However, four more approaches are available: last in, first out (LIFO), dollar value LIFO, average cost (only for mutual fund shares), and particular share identification.

The optimum option will be determined by numerous considerations, including the base price of the shares or units acquired and the amount of gain that will be reported. In difficult circumstances, you may need to visit a tax adviser.

Calculating your cost basis might be difficult. If you use an online broker, your statements will be available on the broker’s website. In any case, be certain that you keep accurate records in some manner.

If you have lost the original confirmation statement or other papers from that period, determining when and at what price an asset was acquired may be a nightmare. This is particularly difficult if you need to identify how much you made or lost when selling a stock, so maintain track of your statements. Those dates will be required for the Schedule D form.

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When Do You Owe Capital Gains Taxes?

You must pay capital gains tax in the year in which you realize the gain. For example, if you sell some stock shares in 2022 and earn a total profit of $140, you must declare that $140 as a capital gain on your 2022 tax return.

Most assets are subject to capital gains taxes if they have been held for at least one year. A Schedule D form is used to report taxes.

Depending on your taxable income for the year, the capital gains tax rate is 0%, 15%, or 20%. High-income earners pay more. Annually, the income levels are updated for inflation. (The capital gains tax rates for the tax years 2021 and 2022 are shown in the tables above.)

Profits from assets held for less than a year are termed short-term gains and are taxed as regular income. That is a greater rate for the majority of individuals.

How Can You Avoid Capital Gains Taxes?

If you invest money and profit, you must pay capital gains taxes on that earnings. However, there are a variety of totally legal strategies to reduce your capital gains taxes:

  • Keep your investment for at least a year. Otherwise, the profit is classified as ordinary income, and you would most likely be taxed more.
  • Remember that your investment losses might be deducted from your returns at a rate of up to $3,000 each year. Some investors take advantage of this fact. For example, they may sell a loser towards the end of the year to balance their profits for the year.
  • If your losses exceed $3,000, you may carry them forward and deduct them from your capital gains in subsequent years.
  • Keep account of any qualifying costs you spend in the course of creating or maintaining your investment. They will raise the investment’s cost basis, lowering its taxable profit.

What Is Good About Reducing the Capital Gains Tax Rate?

Proponents of a low capital gains tax believe that it provides an excellent incentive to save and invest in stocks and bonds. Increased investment drives economic development. Businesses now have the resources to develop and innovate, hence generating more employment.

They also point out that investors are purchasing such assets with after-tax dollars. The money they spend to purchase stocks or bonds is already taxed as regular income, so adding a capital gains tax amounts to double taxation.

What Is Bad About Reducing the Capital Gains Tax Rate?

Opponents of a low capital gains tax criticize the fairness of taxing passive income lower than earned income. Low taxation on capital gains spreads the tax burden on working people.

They further contend that a reduced capital gains tax helps solely the tax-avoidance business. That is, rather than investing in low-tax assets, corporations invest in low-tax assets.

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