When you invest in an asset, you might already be looking forward to the potential return – but don’t forget about the taxes you’ll have to pay. It’s a good idea to know as much as you can about the taxes that apply to your asset before you invest.
The capital gains tax is the amount of tax you have to pay on the gains you make from the sale of an asset. That might sound straightforward, but there’s more to it than that.
There are different rates assessed depending on when the sale goes through, and there are special rules for the sale of certain assets. If that sounds confusing, you’re not alone!
Knowing what can incur capital gains taxes is the first step. Stocks and bonds are common assets that require capital gains tax, but they’re not the only ones. If you own any common assets or any of the specialty assets we describe below, it’s a good idea to start planning for your capital gains tax bill now.
Want to find out what those taxes will look like? Take a look at the answers to these questions.
What’s Subject to Capital Gains Tax?
Houses, cars, stocks, and bonds are all assets subject to capital gains tax. But they’re not the only investments that can land you with this tax. Jewelry, coin collections, and real estate properties are three other common assets also subject to the capital gains tax.
How Do You Calculate Capital Gains Tax?
According to Ben Smith, a financial advisor with Cove Financial Planning, “The amount in tax that you may be subject to is the amount that you sold an asset for minus what you paid for it.”
For example, if you buy a stock for $25 per share, and it grows to $50 per share, then you owe the IRS a percentage of that gain. When you sell the stock, you will need to pay capital gains tax on the $25 per share in gains.
Pay attention to the original investment and the increase in value, because you’ll be taxed on that total amount. However, there are some assets where this total will positively influence the amount you’ll be taxed on.
When you purchase certain assets, the purchase price you paid for them becomes part of your cost basis. For example, imagine you purchase a building at a sale price of $300,000. If you spend $50,000 renovating it, then your cost basis for that asset is $350,000.
If you sell that building for $500,000, then you will be taxed only on the difference between the new sale price and your cost basis, meaning you’ll only pay taxes on your $150,000 gain, instead of $500,000.
What Are Long-Term Capital Gains?
If you purchase an asset and wait more than a year to sell it, then you will be subject to the long-term capital gains tax schedule. This schedule depends on your filing status and income.
However, there’s a potential change on the horizon for this rate. President Biden wants to increase the long-term capital gains tax for individuals earning $1 million or more to 39.6%. While it hasn’t happened yet, this is a change to look out for in the coming years.
It’s also important to know your net totals. Your net long-term capital gains are equal to your long-term capital gains less your capital losses. Your tax amount will be determined based on your net long-term capital gain.
There’s a key benefit to holding onto an asset for more than a year. Long-term capital gains are taxed at lower rates than short-term capital gains – meaning that waiting for more than a year could net you some impressive tax savings.
What Are Short-Term Capital Gains?
Short-term capital gains are applied to assets that you purchase, sell, and profit off of in less than a year. The gain you receive from the sale is treated like – and taxed like – wages or salaries.
That means the gain is taxed at the same rate as your regular earnings, with the exception being if the gain pushes you into a higher marginal tax bracket. This rate will be higher than the long-term capital gains rate.
Your net short-term capital gains are equal to your short-term capital gains less your capital losses. The net amount is what you will be taxed on, so you should make sure you know what that amount is.
While it might be to your advantage in some situations to purchase and sell an asset in less than a year, don’t forget about the high short-term capital gains tax rate.
Long-Term versus Short-Term in Action
Take the time to do the math and compare your long-term and short-term capital gains tax rate before you sell an asset. Certified financial planner Michael Shea explains with this example:
“If you sell a stock for $50,000 and you have $20,000 for your cost basis you will have a capital gain of $30,000, which would be subject to capital gains tax. If you held this stock for less than a year you would be taxed at your ordinary income rate of roughly 32%.”
That tax rate of 32% might seem pretty steep – and it is, especially when you compare it to the long-term capital gains tax rate. Long-term capital gains tax rates are taxed at 15%, less than half of the short-term rate of 32%. In this situation, you’d save $5,100 by waiting to sell the stock until a year has passed and you’re eligible for the long-term capital gains rate.
If you’re buying and selling multiple assets, then the savings from waiting more than a year will add up quickly!
Not all assets are equal in the eyes of the IRS. There are some items that have their own specific tax rates, no matter what.
No matter what your income is, if you make gains on certain collectibles, those gains will be taxed at 28%. It doesn’t matter if your income puts you in a lower tax bracket or a higher one; when you make gains on the sale of artwork, stamp collections, antiques, precious metals, and jewelry, you’ll have to pay 28% in taxes, according to Investopedia.
Real estate also is in its own category. If you profit from the sale of the house that you’ve been living in as your primary residence for at least two years, you can only be taxed on $250,000 of the sale (if you’re filing as a single taxpayer – the amount increases to $500,000 if you’re married filing jointly).
Offsetting Your Losses
Even the most promising investments don’t always deliver the results you expect. Losses can and do happen, and sometimes, they’re disastrous.
When you lose more than you gain, you may be able to offset that loss. Specifically, if you lose more than $3,000 worth of capital, you might be able to take that amount off your capital gains tax for that year.
Some investors strategically leverage offsetting rules. They will buy and sell similar assets within a timeframe, allowing them to take the tax hit earlier on, taking advantage of the lower capital gains rate.
However, it’s important to be careful with this type of tax-loss harvesting. More specifically, you should know that if you buy and sell one security or fund, you cannot repeat this action with an extremely similar security or fund. The IRS will probably disallow the loss rules in this situation.
It’s not possible to offset the losses from the sale of every asset. One of the most common examples is that if you sell the home where you’ve been living for at least two years at a loss, then you cannot deduct your capital losses from your capital gains. This is an IRS law that applies to personal property specifically.
Pay Attention to Your Gains, Losses, and Timing
When tax time rolls around, you need to be prepared. Take some of the stress away by figuring out ahead of time what your capital gains tax burden will be. You can take advantage of an online capital gains calculator, or you can always work with a financial advisor to determine how much you will need to set aside for taxes.
Remember that long-term capital gains are taxed at a lower rate than short-term capital gains. This fact should influence your decision-making about when to sell your assets. It’s also essential that you deduct your losses from your gains, and that if you have more total losses than gains, you take advantage of the $3,000 rule.
It’s wise to keep the future in mind. If you are retiring soon, you might want to wait to sell assets at a gain. If you coordinate the sale so that it aligns with your drop in income from retirement, you could possibly reduce or even avoid a capital gains tax.
Once you have the right tools and information, it’s easier to understand how the capital gains tax applies to your assets. Working with a financial advisor will help you understand how to work with your assets so that you can secure the best possible outcome.