What Is Capital Gains Tax? 5 Things To Know

The capital gains tax is a government fee, which is levied by the IRS as a percentage of the net profit made by an individual or firm in the act of selling certain capital assets. In this context, it is important to understand the difference between realized and unrealized gains for the purpose of tax calculation since you won’t pay any tax until you have realized a gain.

What is a Capital Asset?

For individuals, a capital asset represents anything a person owns for personal or investment purposes. The most common capital asset owned by U.S. taxpayers is their primary house or real estate property. Examples of capital assets include household furnishings, stock investments, cars and gold.

What is a Capital Gain?

When a capital asset is sold for a profit (i.e. the sale price is higher than the cost of purchase), it is classified as a capital gain. Long-term gains from the sale of a capital asset are taxed at a lower rate compared with regular income tax rates. Capital gains taxes are progressive and similar to income taxes. If you make a profit by selling your financial assets, house, car or even a costly personal item, it is considered a capital gain and will be taxed accordingly.

If such assets are sold at a price lower than the cost of purchase, the individual is considered to have incurred a capital loss. Capital losses are not ideal, but if you have made capital gains on the sale of a different asset that same year, you may be able to use the loss to your advantage. You can use capital losses to offset gains. For example, if you sold a stock for $5,000 in profit this year and sold another at a $3,000 loss, you’ll be taxed on net capital gain of $2,000.

While taxpayers can declare capital losses on financial assets, they can also declare losses on hard assets (such as real estate, precious metals or collectibles) if they were not for personal use. Capital losses, either short- or long-term, can offset short- and long-term gains.

Presently, the capital gains tax rates are either 0%, 15% or 20% for most assets held for more than a year. Capital gains tax rates on most assets held for less than a year correspond to ordinary income tax brackets (10%, 12%, 22%, 24%, 32%, 35% or 37%). Notably, for 2017, the top tax bracket was 39.6%, but the Tax Cuts and Jobs Act changed the top income tax rate to 37% for the 2018-2025 tax years.

Short-Term Versus Long-Term Capital Gains

The federal government taxes all capital gains. Short-term capital gains or losses occur when you've owned an asset for a year or less. Long-term capital gains or losses occur if you sell it after owning it for more than a year.

Short-term capital gains have a higher tax rate and get taxed at a standard rate based on your income bracket compared to long-term capital gains to discourage short-term trading. Trading stocks and other assets frequently can increase market volatility and risk. It also costs more in transaction fees to individual investors.

Time plays a significant role in how much you pay in taxes. If a short-term investment becomes a long-term investment, by the time you sell the asset, you could be paying less tax on the gains you make. The capital gains tax is due once you sell your investment. For example, you won't owe any tax while a stock gains value inside your portfolio. Once you sell the shares, your profit must be reported on your tax return. That's when you pay a tax on it at the capital gains rate.

How to Minimize Capital Gains Taxes

Here are a few ways to minimize capital gains taxes.

Hold on: If possible, hold an asset for more than a year so that you can qualify for the long-term capital gains tax rate, since it’s significantly lower than the short-term rate for most assets.

Use Tax-Advantaged Accounts: These include 401(k) plans, individual retirement accounts (IRA), and 529 college savings accounts, in which investments grow tax-free or tax-deferred. This means you don’t have to pay capital gains tax if you sell investments within these accounts. Roth IRAs and 529s in particular have big tax advantages. With traditional IRAs and 401(k)s, you have to pay taxes when you take distributions from the accounts in retirement.

Bottom Line

Minimizing taxes is an important element of the financial planning process. The two main ways to reduce the tax you pay are to hold stocks for more than a year and allow investments to compound tax free in retirement-savings accounts.

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