If you've made several investments that have performed really well and appreciated in value, you might be keen to sell them and reap the profits. If you do sell your assets and turn up a profit, that's wonderful news.
Well, it's equally important for you to know all about the capital gains tax, which impacts your profit margins every time you sell an asset.
Here's a simple guide to help you know more about capital gains and understand the amount of capital gains taxes you need to pay. Let's get acquainted with the basics first.
Basics About Capital Gains
Capital gains are the realized profits when you sell an investment asset. Assets can include stock market shares, mutual funds, bonds, jewelry, properties, and collectibles.
The main word to remember is 'sell'. For example, if you invested $300 in a stock and its value has appreciated to $2000, but you have not sold it, then capital gains do not apply.
When filing your taxes, you'll need to add the profits to your income and pay a capital gains tax. Typically, capital gains are subject to both federal and state-level taxes.
The amount of capital gains tax you pay depends on a number of factors - the duration of holding the asset before selling, what is your filing status, and the profit realized from the sale.
Short-Term Capital Gains Tax
Short-term capital gains tax is the term given to taxes when you sell an asset after holding it for one year or less. Typically, short-term capital gains tax rate is the same as your income tax bracket i.e. 10%, 12%, 22%, 24%, 32%, 35%, or 37%.
To understand this better, let's consider the example of Sophia, a single working professional residing in San Francisco.
Sophia purchased an asset for $12,000 and sold it for $15,000 after holding it for less than a year. Her annual income is $50,000. Without any deduction, her capital gains tax will be $939.
Long-Term Capital Gains Tax
Long-term capital gains tax is the term given to taxes on profits when you sell an asset after buying and holding it for more than a year.
The long-term capital gains tax rate are 0%, 15%, or 20%, and are usually much lower than short-term capital gains tax rates. So essentially, if Sophia had sold her asset after a year, she would have paid just $729.
The capital gains tax rules for home sales are different. Understanding the rules and planning the sale accordingly can help reduce your capital gains tax.
2020 Capital Gains Tax Rates
2021 Capital Gains Tax Rates
How to Calculate Capital Gains Tax
It's a good idea to use a capital gains tax rate calculator to help you understand how much tax you owe. However, before you begin, take note of the following factors:
1. Duration of Holding
In 2020, if you held the asset for over a year, the tax rates are 0%, 15%, or 20%. The tax rates are the same as income tax rates if the assets are held for less than a year.
2. Filing Status
There are five categories that you may fall into based on your marital status:
- Single
- Married, filing jointly
- Married, filing separately
- Qualified widower
- Head of household (HOH)
Single-status taxpayers often end up paying more taxes.
3. Profits
The more profit you earn, the more capital gains tax you need to pay. However, you can maximize your net profits with long-term investments as they are generally taxed at lower rates.
4. Capital Losses
While you earn capital gains on some assets, you might also experience capital losses on another asset. For example, if you earn capital gains of $5,000 on an asset and experience a loss of $2,000 on another, you will be taxed on capital gains of $3,000.
When adding a value in the "initial value" and "sale value" fields in a capital gains tax calculator, add the initial value of all assets and the sale value of all assets.
5. Net Capital Gain
"Net capital gain" is the name given to the difference between your capital gains and capital losses.
Some years, your capital losses might exceed your capital gains. In this case, it's best to deduct the difference on your tax return, up to $3,000 per year. If you are file under the "married, filing separately" status, you can deduct up to $1,500.
Try out our Capital Gains Tax Calculator:
Capital Gains: Exceptions to the Rule
There are certain cases where the rules are slightly different, based on the asset and the profile of the taxpayer.
For instance, collectible assets like art, antiques, coins, cards, comics, precious metals, and antiques are taxed slightly differently. Long-term capital gains are taxed at 28%, while short-term capital gains are taxed at the regular income tax rate.
A "Net Investment Income Tax" (NIIT) is imposed by section 1411 of the Internal Revenue Code (IRC). Under this rule, a 3.8% NIIT applies to your net investment income if it crosses the statutory threshold amounts.
Here's a run-down of income thresholds that make investors subject to NIIT:
- Single/HOH: $200,000
- Married, filing jointly: $250,000
- Married, filing separately: $125,000
How to Reduce Your Capital Gains Tax
To minimize your capital gains tax burden, you need to wise up about all taxation rules, carefully plan your investments, and strategically sell your assets. The following tips can help in this endeavor:
1. Don't Sell Before One Year
The capital gains tax on assets held on for more than a year is significantly lower than for assets held on for less than a year. This way, you are subject to long-term capital gains tax rate, which gives you an advantage.
2. Change Your Filing Status
Consider filing jointly with your spouse to get a tax advantage. If you are married and file taxes separately, you end up paying more capital gains tax.
3. Use Tax-Advantaged Accounts
When planning investments, make sure to invest money in accounts that come with a tax advantage, such as:
- 401(k) plans
- Individual retirement accounts
- 529 college savings accounts
Here, your investments grow tax-free or might be tax-deferred, i.e., no capital gains tax applies if you sell investments within these accounts.
Additionally, you don't need to pay any taxes on Roth IRAs and 529s. However, with traditional IRAs and 401(k)s, you pay taxes when you take distributions during retirement.
If you are self-employed or a small business owner, you can look at Simple IRA, Solo 401 (k), Solo Roth 401 (k), and SEP IRA.
4. Know the Rules Before Selling Your Home
You can get an exclusion of up to $250,000 in capital gains if you are single and up to $500,000 if you’re married and filing jointly, on the following conditions:
- If you used your home as your place of residence for at least two years in the five-year time frame before selling it.
- You have not excluded another home from capital gains two years before your home sale.
Understanding these rules can help you significantly bring down capital gains tax during your home sale.
5. Carry Over Capital Gains Losses
You can carry forward the losses from capital gains if the total amount exceeds the $3,000 limit. This allows you to deduct the excess loss on next year’s return, but you should keep track of these carryovers so that you don't miss out on them come tax season.
6. Leverage Investment Losses
You can leverage losses to offset the capital gains tax on profitable investments. So if you sold a stock for a profit of $3,000 and another at a loss of $500, your capital gains would be $2,500.
The Takeaway
If you're a first-time investor, this is the best time to familiarize yourself with all the rules of capital gains tax to maximize your profits. As a seasoned investor looking to grow your portfolio even further, you can plan the sale of your asset.
As you grow as an investor and expand your portfolio, you will need to plan investments and the sales of assets even more carefully. Getting a professional to support you is a good way to make sure you are on top of things.
You can also get assistance from Fincent, a professional service that helps small business save time and money with their bookkeeping activities.