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BEGINNER’S GUIDE TO CAPITAL GAINS

Here’s everything you need to know about capital gains, how it works, ways to reduce capital gains tax, and more.

CAPITAL GAIN: HOW DOES CAPITAL GAIN TAX WORK? 

The term capital gain is a profit earned from selling an asset/investment. 

A tax on the profit realized by individuals and corporations from the sale of non-inventory assets such as stocks, bonds, real estate, property, and precious metals is called capital gains tax. Long-term gains are taxed at 15%. 

Say for example you bought 50 shares of ABC stocks at $30 per share and sold them more than a year later for $70 per share. Long-term gains are taxed at 15%. Expressed as an equation, that means:

            $2,000       =   $3,500            –       $1,500

          Capital Gain        =    Selling Price          –       Purchase Price

In this example, $300 of your profit will go to the government, and the profit after tax is $1,700. 

Capital gain is not merely limited to stocks, mutual funds, and bonds. This can also apply to collectibles, real estate, and anything else that can be considered as an investment.  

REALIZED GAIN VS. UNREALIZED GAIN

Knowing the difference between realized gain and unrealized gain is important.

A realized gain is when the selling price is higher than the original purchase price. Capital gains are taxed only when sold and realized. Investments that have not yet been sold and just potential profits are considered as unrealized gains.

QUALIFYING ASSETS FOR CAPITAL GAINS TREATMENT

Capital gains treatments are taxes being imposed on assets but not every capital asset that you own will qualify for capital gains treatment including business inventory, depreciable business property, and non-capital assets such as musical or artistic composition, letter, and memorandum.

UNDERSTANDING LONG-TERM AND SHORT-TERM CAPITAL GAINS

Assets must be held for more than a year to qualify for the most favorable long-term capital gains rates.

Any gains on assets that have been held for a year or less are short-term capital gains. It’s almost always taxed at a higher rate which can range from 10% to as high as 37%.

TAXATION RATES  

Over the years, tax brackets have changed.  Long-term capital gains rates are 0%, 15%, and 20% depending on one’s tax bracket. Rates are much lower than the ordinary tax rate. 

Some taxpayers may owe an additional 3.8% tax on investment income depending on one’s modified adjusted gross income and filing status.  The income threshold that is subject to this additional tax is as follows: 

  • Single or head of household: $200,000
  • Married, filing jointly: $250,000
  • Married, filing separately: $125,000

© https://www.fool.com/retirement/2018/12/09/long-term-capital-gains-tax-rates-in-2019.aspx

Two types of capital gain taxes that you may encounter:

  • On collectibles, 28% rate is being taxed on artworks, stamp collections, etc.
  • You can sell your home and be exempt from capital gains tax. Based on the Internal Revenue Service (IRS) you must have occupied the residence for at least two of the last five years.

REDUCING CAPITAL GAINS TAX

1. Long term Investment 

2. Investing money through a retirement plan

3. Taking advantage of an investment loss by decreasing the tax on your gains on other investments

4. Watching holding periods

5. Determining cost basis

What are the capital gains tax rates for 2020 and 2021?

While the capital gains tax rates remained the same as before under the Tax Cuts and Jobs Act of 2017, the income required to qualify for each bracket goes up each year to account for workers’ increasing incomes. Here are the details on capital gains rates for the 2020 and 2021 tax years.

Long-term capital gains tax rates for the 2020 tax year

FILING STATUS0% RATE15% RATE20% RATE
SingleUp to $40,000$40,001 – $441,450Over $441,450
Married filing jointlyUp to $80,000$80,001 – $496,600Over $496,600
Married filing separatelyUp to $40,000$40,001 – $248,300Over $248,300
Head of householdUp to $53,600$53,601 – $469,050Over $469,050

Source: Internal Revenue Service 

Long-term capital gains tax rates for the 2021 tax year

FILING STATUS0% RATE15% RATE20% RATE
SingleUp to $40,400$40,401 – $445,850Over $445,850
Married filing jointlyUp to $80,800$80,801 – $501,600Over $501,600
Married filing separatelyUp to $40,400$40,401 – $250,800Over $250,800
Head of householdUp to $54,100$54,101 – $473,750Over $473,750

Source: Internal Revenue Service 

For example, in 2020, individual filers won’t pay any capital gains tax if their total taxable income is $40,000 or below.

However, they’ll pay 15 percent on capital gains if their income is $40,001 to $441,450. Above that income level, the rate jumps to 20 percent.

In 2021, individual filers won’t pay any capital gains tax if their total taxable income is $40,400 or less. The rate jumps to 15 percent on capital gains if their income is $40,401 to $445,850. Above that income level, the rate climbs to 20 percent.

In addition, those capital gains may be subject to the net investment income tax (NIIT), an additional levy of 3.8 percent if the taxpayer’s income is above certain amounts. The income thresholds depend on the filer’s status (individual, married filing jointly, etc.).

Meanwhile, for short-term capital gains, the tax brackets for ordinary income taxes apply. The 2020 tax brackets are 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.

Unlike the long-term capital gains tax rate, there is no 0 percent rate or 20 percent ceiling for short-term capital gains taxes.

(source: https://www.bankrate.com/investing/long-term-capital-gains-tax/) 

Exceptions to Capital Gains Taxes

For some kinds of capital gains, different rules apply. These include capital gains from the sale of collectibles (like art, antiques, and precious metals) and owner-occupied real estate.

Capital Gains Taxes on Owner-Occupied Real Estate

If you sell your home for a profit, that’s considered a capital gain. But you may be able to exclude up to $250,000 of that gain from your income, or up to $500,000 if you and your spouse file a joint tax return.

To qualify, you must pass both the ownership test and the use test. This means you must have owned and used the real estate as your main home for a total period of at least two years out of the five years before the sale date. The two-year periods for owning the home and using the home don’t have to be the same two-year periods. Typically, you can’t take this exclusion if you’ve taken it for another home sale in the two years before the sale of this home.

Capital Gains Taxes on Collectibles

If you realize long-term capital gains from the sale of collectibles, such as precious metals, coins, or art, they are taxed at a maximum rate of 28%. Remember, short-term capital gains from collectible assets are still taxed as ordinary income. The IRS classifies collectible assets as:

  • Works of art, rugs, and antiques
  • Musical instruments and historical objects
  • Stamps and coins
  • Alcoholic beverages (think valuable old wine)
  • Any metal or gem

The latter point is worth reiterating: The IRS considers precious metals to be collectibles. That means long-term capital gains from the sale of shares in any pass-through investing vehicle that invests in precious metals (such as exchange-traded funds or mutual funds) are generally taxed at the 28% rate. 

What is the Net Investment Income Tax?

What is the Net Investment Income Tax?

For people earning income from investments above certain annual thresholds, their investment income tax comes into play. Net investment income includes capital gains from the sale of investments that haven’t been offset by capital losses – as well as income from dividends and interest, among other sources. The net investment income tax is an additional .8% surtax. 

Who Owes the Net Investment Income Tax?

Individuals, estates, and trusts with income above specified levels own this tax on their net investment income. If you have net investment income from capital gains and other investment sources, and a modified adjusted gross income above the levels listed below, you will owe tax. 

source: https://www.forbes.com/advisor/investing/capital-gains-tax/ )


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