Have you downsized your home or had the opportunity to sell stocks this year? Are you wondering about the tax implications? If you made a profit this year from selling larger-ticket items, you may be on the hook to pay a capital gains tax.
What Is Capital Gains Tax?
If you made money from the sale of an asset, like a piece of land, a business or a share of stock, this is considered taxable income. These profits are considered “taxable gains.” The tax you pay on this is known as a capital gains tax. There are two types of capital gains tax:
- Short-Term Capital Gains Tax — This is a tax levied on property held for a year or less. The income you receive from a short-term investment that led to capital gains is simply factored into your income tax rate.
- Long-Term Capital Gains Tax — This is a tax on profits from the sale of property that you have held for more than a year. Tax rates are 0%, 15% or 20%. The rate you are taxed at is determined by the income tax bracket you fall into on your income tax filing status.
When Do I Pay Capital Gains Tax?
If you sell or exchange a capital asset for more than its cost, the profit is a capital gain. If you sell or exchange a capital asset at a loss, you can generally use the loss to offset capital gains. If your capital losses exceed your gains, you can offset a certain amount of ordinary income and/or carry the loss forward into future tax years.
Capital gains taxes are generally reserved for things like real estate and stocks, but can be applied to “collectible assets” like coins, precious metals, art and antiques. Generally speaking, the profit you earn from selling these types of things will be taxed at 28% (rather than applied to your income as a long-term gain). If you have owned these items for a year or less at the time of the sale, you would add the income you earned into your income tax rate (as you would with any other short-term capital gain).
How Can I Reduce My Tax Burden?
Use your earnings wisely
If you are looking to avoid paying hefty tax fees, it may be wise for you to put your earnings — your gains — into a tax-advantaged account, like a 401(k), individual retirement account (IRA) or 529 college savings account. These accounts grow tax-free or tax-deferred, meaning you may avoid taxes until the funds are dispersed.
Under the homesale exclusion, gain on the sale of your principal residence (up to certain limits) can be excluded from income, as long as certain conditions are met.
Time your capital gain recognition
Careful planning may save you taxes. For example, because capital gain or loss is not recognized for federal income tax purposes until you dispose of an asset, in many cases you have some control over the timing of recognition. If you believe that you will be in a lower tax bracket next year, you can choose to postpone the sale of a capital asset to defer recognition of gain or loss until that year.
Plan your year-end capital gain and loss status
If you realize a capital gain this year, you should consider reviewing your portfolio for potential losses, and decide whether it makes sense to recognize losses to offset your gain. Remember also that you can use up to $3,000 ($1,500 if married filing separately) worth of losses (if applicable) to offset ordinary income.
Similarly, if you have a capital loss this year (or have a capital loss carryforward), you should review your portfolio for potential gains for offset purposes. This may help to lower your overall tax liability.
For property held as an investment, elect to include gain in investment income
You may elect to treat capital gains from investment property as investment income instead. If such an election is made, gains will be taxed at ordinary rates and can be used to offset investment interest expenses. This may be advantageous for individuals who have sufficient capital losses to offset capital gains, and insufficient investment income to offset investment interest expenses.
Frequently Asked Questions
How Do Capital Gains Tax Rates Differ From Ordinary Income Tax Rates?
Capital gain income is generally preferable to ordinary income. Currently, the highest marginal income tax rate is 37 percent, while long-term capital gains tax rates vary from 0 percent to 28 percent, depending on the asset and your taxable income. Generally, current long-term capital gains tax rates can be grouped as follows:
- 28 percent for collectibles and small business stock
- 25 percent for unrecaptured IRC Section 1250 gain
- 0 percent, 15 percent, and 20 percent for most long-term capital gains and qualified dividends, depending on your taxable income.
The tax rate that will apply to the sale or exchange of a capital asset depends on a number of factors, including the type of asset, how long you owned (held) the asset, and your taxable income.
If your capital gain in a given year pushes you into a higher capital gain tax bracket, which capital gain rate do you use?
Suppose you are normally in the 0 percent capital gain tax bracket, but in December of this year, you sell an asset held for two years and realize a substantial long-term capital gain. Will the full capital gain be untaxed because of the 0 percent rate? Maybe not. If your capital gain pushes you into a higher capital gains tax bracket, you can use a preferred capital gains tax rate of 0 percent on a portion of the capital gain only. The remainder of your capital gain will be taxed at the higher 15 percent rate.
Example: Assume John has taxable income that is $10,000 less than his capital gains rate threshold for 15 percent. He realizes a long-term capital gain of $40,000 and his taxable income increases to $30,000 greater than his capital gains rate threshold for 15 percent. $10,000 of his net capital gain is taxed at 0 percent and $30,000 is taxed at 15 percent.
What are the netting rules?
Capital gains and losses may offset one another based on a set of principles known as the "netting rules." Generally speaking, the tax code prescribes that short-term capital gains and losses must be netted against each other first. Next, long-term capital gains and losses are netted against one another according to a set of ordering rules. Finally, net short-term gains or losses must be netted against net long-term gains or losses in a prescribed manner.
Capital losses are netted against capital gains. Up to $3,000 in excess capital losses is deductible against ordinary income each year. Unused net capital losses are carried forward indefinitely and may offset capital gains, plus up to $3,000 of ordinary income during each subsequent year. (The $3,000 limit is reduced to $1,500 for married persons filing separately.)
Example: Assume Jane has a short-term capital gain of $1,200 and a short-term capital loss of $1,300, resulting in a net short-term capital loss of $100. She also has a net long-term capital gain of $600 and a net long-term capital loss of $4,200, resulting in a net long-term capital loss of $3,600. The excess of Jane's capital losses over capital gains is $3,700 ($100 + $3,600). This excess is deductible from ordinary income up to a maximum of $3,000 this year; the remainder may be carried over to future years.
When you carry over a loss, it retains its original character as either long-term or short-term (e.g., a short-term loss you carry over to the next tax year is added to short-term losses occurring in that year, and a long-term loss you carry over is added to long-term losses occurring in that year). A long-term capital loss you carry over to the next year reduces that year's long-term gains before its short-term gains. If you have both short-term and long-term losses, short-term losses get used first in calculating your allowable loss deduction.
What are qualified dividends?
Qualified dividend income generally includes dividends received from domestic corporations and qualified foreign corporations. If holding period requirements are met, qualified dividends are taxed at the same rates that apply to net capital gain. For purposes of calculating federal income tax, qualified dividends are taxed at the same maximum rates that generally apply to long-term capital gains. For this purpose only, they are added to net capital gain and adjusted net capital gain in the capital gain tax calculation. However, qualified dividends are not netted against capital gains and losses, and capital losses cannot be used to offset qualified dividend income.
Ask a Professional
Not sure if what you sold counts as a capital gain? The provisions can be confusing! If you have questions, consult with a financial professional. They can help you understand the specific provisions it takes to be considered a capital gain, and they can clarify your tax liability for the gains you received. Talk to your Farm Bureau agent or financial advisor for more information.