Learn about how you can reap the rewards of investing in the most tax-advantaged asset class in America.
The basic idea of capital gains is quite simple: If you sell an asset for more than you paid for it, the net profit is known as a capital gain. For example, if you pay $1,000 for a stock investment and sell it for $1,500, the $500 profit you made is a capital gain.
Like most other forms of income, capital gains are generally taxable. This is known as capital gains tax. With that in mind, here's a rundown of how the IRS treats capital gains for tax purposes, the 2020 capital gains tax brackets, and a few strategies you can use to minimize or even avoid paying capital gains taxes.
Short-term vs. long-term capital gains
Here's the first important capital gains tax concept investors need to know.
The IRS separates all capital gains into two main categories – short-term and long-term. A short-term capital gain occurs when you sell an asset that you've owned for one year or less. A long-term gain occurs when you owned the asset for at least a year.
In either case, a capital gain is defined as the net profits from the sale of an asset. If you pay any transactional costs, such as sales commissions, you can take those into account when calculating your capital gains.
Long-term capital gains tax brackets in 2020
Long-term capital gains get the lower tax rates of the two types. Depending on the taxpayer's total taxable income, long-term gains are taxed at rates of 0%, 15%, or 20%, with 15% being the most common rate of the three by far.
For the 2020 tax year (the tax return you'll file in 2021), here are the three capital gains tax income tax brackets for the various tax filing statuses. Remember that these figures represent taxable income, not adjusted gross income (AGI) or gross income:
|Long-Term Capital Gains Tax Rate||Single Filers (taxable income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|0%||$0 - $40,000||$0 - $80,000||$0 - $53,600||$0 - $40,000|
|15%||$40,000 - $441,450||$80,000 - $496,050||$53,600 - $469,050||$40,000 - $248,300|
|20%||Over $441,450||Over $496,050||Over $469,050||Over $248,300|
It's also worth mentioning that these capital gains tax rates are only the federal income tax you might have to pay. You might have to pay capital gains taxes to your state as well.
Short-term capital gains tax rates in 2020
Short-term capital gains are taxed as ordinary income. In other words, they'll be taxed according to the ordinary income tax brackets that apply to earned income. These rates range from 12% to 37%, and while there are seven marginal tax brackets for ordinary income as opposed to just three for long-term capital gains taxes, the long-term rates are generally lower than the corresponding ordinary income tax rates.
The net investment income tax
In addition to the standard tax rates on both short- and long-term capital gains, certain higher-income taxpayers are required to pay an additional 3.8% net investment income tax. This tax helps fund the Affordable Care Act and applies to any income from investments -- including capital gains, interest income, dividends, investment property rental income, and more.
The net investment income tax applies to any income in excess of the following limits that came from investments:
- $250,000 for joint tax filers
- $200,000 for single filers
For example, let's say that you're married filing jointly and that you and your spouse earned $230,000 from your jobs. You also had $30,000 in investment income from stock dividends and bond interest. In this case, you would be assessed the net investment income tax on the $10,000 of the investment income that pushes your total over the $250,000 threshold.
One important point is that this effectively raises the maximum capital gains rates by 3.8%. For long-term gains, the maximum effective federal income tax rate becomes 23.8%, and for short-term gains, it becomes 40.8%, as opposed to 20% and 37%, respectively.
Do you have to pay capital gains tax on real estate sales?
One gray area in the capital gains laws involves real estate -- specifically when it comes to primary residences. After all, your home is certainly an asset, and it is entirely possible (if not probable) to sell your home for more than you paid for it. However, capital gains taxes are intended for investment proceeds, and your primary home is more of a usable asset than an investment.
So, there is a special rule known as the primary residence exclusion. This allows taxpayers to exclude as much as $250,000 in net profits from the sale of their primary home ($500,000 for a married couple filing a joint tax return) from capital gains taxation. For example, if you and your spouse buy a home for $500,000 and sell it for $900,000 years later, the IRS can't touch a dime. Of course, there are some rules that need to be followed, such as complying with the IRS definition of a primary residence.
On the other hand ,investment properties are indeed subject to capital gains taxes. However, a tax strategy known as a 1031 exchange allows for these to be deferred if the proceeds are used to purchase another investment property. More on that later.
Strategies to avoid or minimize capital gains taxes
Of course, nobody likes paying taxes. Fortunately for investors, there are several ways to reduce, delay, or even avoid capital gains taxes on the sale of profitable investments. Just to name a few:
Take advantage of retirement accounts
If you invest through tax-advantaged retirement accounts, such as IRAs, 401ks, and others, you don't have to worry about capital gains taxes. It doesn't matter if an investment is worth a million dollars more than you paid. The IRS won't touch one penny when tax time rolls around. The only tax implication of investing in tax-deferred retirement accounts is that when you withdraw the money, it will be considered taxable income. In after-tax (Roth) retirement accounts, you won't have to pay any taxes at all on qualified withdrawals.
Use losses to offset gains
The IRS allows taxpayers to use their qualifying capital losses to offset their total capital gains. For example, if you have a $5,000 capital gain from the sale of an investment property and a $2,000 capital loss from a stock investment you sold, your taxable capital gain will be reduced to $3,000. Even if your losses exceed your gains, you can use up to $3,000 in excess losses to offset your other taxable income. This is a popular tax strategy known as tax loss harvesting.
Defer gains on investment properties
As I mentioned briefly, you can use a 1031 exchange (also known as a like-kind exchange) to defer capital gains on investment properties, as long as you use the sale proceeds to buy another one. Check out our guide to 1031 exchanges if you want to learn more.
Gift assets to loved ones
If you don't want to pay capital gains taxes on an appreciated asset, you can give it away. For the majority of people, giving away assets won't have any tax implications at all, but for high-net-worth individuals, it could have future estate tax implications.
Think long term
One of the biggest takeaways from this guide is that the U.S. tax code is designed to encourage long-term investments (especially if you're investing for retirement). If you are thinking of selling a stock you've owned for 10 or 11 months, it could be in your best interest to hold on a little longer. If you have an extra $1,000 to invest, consider putting it in an IRA instead of a taxable brokerage account. Thinking long term can end up saving you a boatload of money on your tax bill over the years.
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