If you're reading about capital gains, it's usually because your assets did well. Or you're preparing for it in the future.
When you've developed a low-cost, diverse portfolio and the assets you own are worth more than you bought for them, you can consider selling some of them to generate capital gains.
Capital gains are the profits earned when you sell investments such as stocks or real estate. These include short-term gains for investments kept and sold in less than one year, as well as long-term gains for those held and sold in more than a year.
Capital gains and losses will either raise or lower the value of your investment. However, you only have to pay capital gains taxes after selling an investment; the money you earn from an investment is taxed at both the federal and state levels. However, you should be aware that selling a losing investment may allow you to reduce your capital gains taxes (more on tax harvesting below).
A financial advisor can assist you in managing your investment portfolio. To discover a financial advisor in your neighborhood, use SmartAsset's free online matching tool.
Assume you acquire some stock at a low price, and after a given amount of time, the value of that stock has increased significantly. You decide to sell your stock and profit from the increase in value.
The profit you make when you sell your stock (or other similar assets such as real estate) is equivalent to your capital gain on the sale. The Internal Revenue Service taxes capital gains at the federal level, and certain states tax capital gains at the state level. The tax rate you pay on capital gains is determined in part by how long you hold the asset before selling.
Long-term capital gains refer to gains on assets held for more than a year. They are taxed at a lower rate than short-term capital gains.
Depending on your regular income tax bracket, the tax rate on long-term capital gains could be as low as zero. Even people in the highest tax bracket face long-term capital gains rates that are over half of their income tax rates. That is why some wealthy Americans pay less in taxes than you might anticipate.
Short-term capital gains are profits earned from selling assets held for one year or less. They are taxed as regular income. That implies you pay the same tax rates as federal income tax
To summarize, the magnitude of your gains determines the amount you pay in federal capital gains taxes, your federal income tax rate, and how long you've owned the asset in question.
To calculate the extent of your capital gains, you must first determine your basis. The basis is the amount you paid for an asset. The difference between the sale price and the basis of your asset determines how much you owe in taxes or your tax liability. That implies you pay tax on your profits.
Why is there a difference between the federal regular income tax and the tax on long-term capital gains? It boils down to the distinction between earned and unearned money. In the view of the IRS, these two types of income are distinct and require different tax treatment.
Earned income is the amount you make from your job. Whether you run your own business or work part-time at the local coffee shop, the money you make is considered earned income.
Unearned income is derived from interest, dividends, and capital gains. It's money made with other people's money. Even if you actively day trade on your laptop, the revenue generated by your investments is considered passive. So, in this example, "unearned" does not imply that you don't deserve the money. It simply means that you earned it in a different method than a traditional income.
The topic of how to tax unearned income has become a political one. Some argue that it should be taxed at a greater rate than earned income tax because it is money earned without working rather than through the sweat of their brow. Others believe the rate should be even lower than it is to encourage investment, which drives the economy.
No one loves receiving a big tax bill in April. Tax-loss harvesting is one of the most prevalent and complicated methods for lowering your tax bill.
Tax-loss harvesting is a practice that helps investors avoid paying capital gains taxes. It leverages the money you lose on an investment to balance the capital gains you get when you sell winning investments. This implies you can write off the losses when you sell the depreciated item, canceling out some or all of your capital gains on appreciated assets.
If you wish to repurchase the assets you sold at a loss, you can do so while still receiving a tax write-off if you schedule it correctly. Some robo-advisor firms have discovered ways to automate this process by repeatedly selling investments at a loss and then quickly purchasing a similar asset. This allows you to remain involved in the market while still taking advantage of tax breaks on your losses.
Some investors include tax-loss harvesting into their entire portfolio investment strategy to save money. Others argue that it costs you more in the long run since you are selling assets that you may appreciate in the future in exchange for temporary tax relief. And if you repurchase the shares, you are effectively delaying capital gains taxation until a later year. Critics of tax-loss harvesting further point out that because Congress can modify the tax code, you may face significant taxes when you sell your assets later.
Some states also charge taxes on capital gains. Most states tax capital gains at the same rates as normal income. So, if you're fortunate enough to reside somewhere without a state income tax, you won't have to worry about capital gains taxes at the state level.
New Hampshire, for example, does not tax income but taxes profits and interest. By comparison, states with high-income taxes (California, New York, Oregon, Minnesota, New Jersey, and Vermont) have high capital gains taxes. A decent capital gains calculator, such as ours, considers federal and state taxes.
If you own a home, you may be curious about how the government taxes profits from home transactions. Capital gains on a home, like those on other assets such as stocks, are calculated as the difference between the sale price and the seller's basis.
Your home's basis is the amount you paid for it, plus closing expenses and any non-decorative investments you made on the property, such as a new roof. You can also include sales expenses, such as real estate agency fees, in your basis. Subtracting that from the sale price yields the capital gains. When you sell your principal residence, capital gains of $250,000 (or $500,000 for a couple) are excluded from capital gains tax. This is normally true only if you have owned and utilized your house as your primary residence for at least two of the five years preceding the sale.
If you inherit a home, you will not be eligible for the $250,000 exemption unless you have owned it as your principal residence for at least two years. If you do not satisfy those requirements, you may still be eligible for a break. When you inherit a home, you receive a "step-up in basis."
Assume your mother's base for the family home was $200,000. Today, the home's market worth is $300,000. If your mother leaves the house to you, you will automatically receive a stepped-up basis equivalent to the market value of $300,000. If you sell the home for that amount, you will not have to pay capital gains taxes. If you later sell the home for $350,000, you will only owe capital gains taxes on the $50,000 difference between the sale price and your stepped-up basis. If you've owned it for more than two years and used it as your primary residence, you won't have to pay capital gains taxes.
The stepped-up base is somewhat contentious and may not be around forever. As always, the greater the value of your family's estate, the more important it is to seek a professional tax counsel who can assist you in minimizing taxes if that is your objective.
Under some conditions, the net investment income tax, or NIIT, may affect the income you earn from your investments. While this tax primarily affects individuals, it can also be assessed on estate and trust income. The NIIT is based on the lesser of your net investment income or the amount by which your modified adjusted gross income (MAGI) exceeds the IRS's NIIT levels. These thresholds depend on your tax filing status, and they are as follows.
• Single: $200,000.
• Married filing jointly: $250,000.
• Married filing separately: $125,000.
• Qualifying widow(er) with dependent children: $250,000.
• Head of household: $200,000.
NIIT's tax rate is 3.8%. The tax only applies to United States citizens and resident aliens; nonresident aliens are not obligated to pay it. The IRS defines net investment income as interest, dividends, capital gains, rental income, royalty income, non-qualified annuities, income from businesses that trade financial instruments or commodities, and income from businesses that are passive to the taxpayer.
Here's an illustration of how the NIIT operates: Assume you file your taxes jointly with your spouse and have a total income of $200,000. The filing status level is $250,000. Therefore, you do not owe the NIIT solely on that income. However, you also earn $75,000 in net investment income from capital gains, rental income, and dividends, bringing your total income to $275,000. Because your income is now $25,000 above the threshold, and that figure is the lesser of $75,000 (your total net investment income), you will owe taxes on that $25,000. At a tax rate of 3.8%, you'd have to pay $950.