Capital Gains are the profit made from the sale of a capital asset like property, vehicles, or any other type of investment. The profit earned from the sale of a capital asset is also known as income from capital gains. However, did you know that this income is taxable in the year in which the transfer of capital assets takes place?
If you are also considering selling or investing in a capital asset, learning more about Capital Gains Tax is essential. In the eyes of the IRS, the profit you make from the sale of investments like stocks or another capital asset like real estate is considered income. It is crucial for an individual to know how it gets taxed, and at what rates.
While investment in real estate or a house is very sought after, most people invest with the intention of selling the property in the future for monetary gain. However, any profit or loss incurred by the sale of a capital asset is subjected to Capital Gains Tax.
In this blog, we will delve into Capital Gains Tax, how does capital gains tax works, and its various types.
What is Capital Gains Tax?
The capital gain tax is a form of tax levy on the profit from the sale of an asset or investment. It is owed for the year during which the capital investment or asset was sold. There are various factors that determine how the capital gains are taxed. It ultimately depends on the filing status, taxable income, and how long the asset was owned before selling.
If the asset was held for longer than a year, the capital gains tax rate is 0%, 15%, or 20% on most assets. However, if the asset was held for a year or less, it corresponds to the ordinary income tax bracket i.e. 10%, 12%, 22%, 24%, 25%, or 37%.
An individual owes long-term capital gains tax for assets and investments held for more than a year whereas if the investor owns the asset for less than a year, he is liable for a short-term capital gains tax. The rate of the short-term tax is determined by the taxpayer’s ordinary income bracket.
How Does Capital Gains Tax Work?
Much like income tax, capital gains tax is also progressive. The profit from selling an investment or asset is considered taxable income by the IRS. Capital gains tax does not apply to unsold investments or unrealized stocks. They won’t incur any taxes until they are sold, despite how long they are held or how much they increase in value.
However, the holding period, meaning the time between when you bought the asset and when you sell it determines the capital gain tax rate for the profit. Profits made on assets held for less than a year incur short-term capital gains tax. Profits made on assets held for more than a year incur long-term tax.
While short-term capital gains are taxed according to the relevant federal tax rate, long–term capital gains are subjected to 0%, 15%, or 20%, depending on your taxable income. According to the IRS, most individuals pay no more than 15% on long-term capital gains.
Most taxpayers pay a higher tax rate on their income than on any long-term capital gains they may have sold. This provides a financial incentive to hold investments for a year, after which the capital gains tax rate will be lower.
It is crucial for day traders who take advantage of speed trading online to be aware that any profits from buying and selling assets and investments held for less than a year are taxed at a higher rate than assets held for the long term.
Types of Capital Gains Tax
Typically, there are two types of capital gains tax- short-term and long-term capital gain tax.
Short-term Capital Gain Tax
A short-term capital gain tax is the levy on profits from the sale of assets or investments held for less than one year. Short-term capital gains are added to your income and taxed at the ordinary rate of income tax, depending on your tax bracket.
How to Calculate Short-Term Capital Gains?
Step-1: Start with the value of Full Consideration
Step 2: Deduct the following expenses
- Expenditure incurred exclusively in connection with such transfer
- Cost of Acquisition
- Cost of Improvement
Step-3: The amount is your short-term capital gains
Short-Term Capital Gain= Full Value Consideration-Expenses incurred for transfer, cost of acquisition, and cost of improvement.
Long-term Capital Gains Tax
A long-term capital gains tax is levied on profits from sales of assets held for more than a year. The long-term capital gains tax rate depends on your taxable income and filing status but is typically around 0%, 15%, or 20%. The tax rates for long-term capital gains tax are generally lower than short-term capital capital gains tax rates.
How to Calculate Long-term Capital Gains?
Step-1: Start with the value of Full Consideration
Step-2: Deduct the following expenses
- Indexed expenditure incurred exclusively in connection with such transfer
- Indexed Cost of Acquisition
- Indexed Cost of Improvement
Step-3: From the resulting sum, deduct exemptions provided under Sectios 54, 54EC, 54F, and 54B.
Long-term Capital Gains = Full Value Consideration-Expenses incurred for transfer, cost of acquisition, cost of improvement, and expenses that can be deducted from the full value of consideration.
The deductible expenses are as follows-
- Sale of Property or Real Estate: The following expenses are deductible from the total sale price-
- Brokerage or Commission paid to secure the purchase
- Cost of stamp papers
- Travelling expenses exclusively in connection with the transfer
- If the property is inherited, the expenses incurred with the procedures associated with the will and inheritance, cost of the executor, and obtaining succession certificate may also be allowed in some cases.
- Sale of Shares or Stocks: The broker’s commission related to the sold shares is deductible from the total sale price.
- Jewellery: In case a broker was used to secure a purchaser, the cost of these services is deductible.
Note: The expenses deducted from the sale price of assets for calculating capital gains are not allowed as a deduction under any other head of income, and you can claim them only once.
Read Also:- Risks of REITs (Real Estate Investment Trusts)
Important Terms to Learn
Full Value Consideration: The consideration received or to be received by the seller as a result of the transfer of their capital assets. Capital gains are liable in the year of transfer even if no consideration has been received.
Cost of Acquisition: The value for which the capital acquisition was bought by the seller.
Cost of Improvement: Capital expenses incurred by the seller to make additions or alterations to the capital asset.
Capital Gain Tax Rates for 2022 and 2023
The profit on an asset that is sold less than a year after it was purchased is generally considered as wages or salary by the IRS. Profit from such sales is added to your earned income or ordinary income on a tax return.
However, a different system is applied for long-term capital gains. The tax you are liable on assets that you sell after holding them for more than a year is based on the taxpayer’s taxable income for that particular year. The table offers an overview of long-term capital gains tax rates based on taxable income.
Long-Term Capital Gains Tax Rates for the Year 2023
|0% tax rate
|15% tax rate
|20% tax rate
|0$ to $44,625
|$44,626 to $492,300
|$492.301 or more
|Married, filing jointly
|0$ to $89,250
|$89,251 to $553,850
|$553,859 or more
|Married. Filing separately
|0$ to $44,625
|$44,626 to $276,900
|$$276,901 or more
|Head of Household
|0$ to $59,750
|$59,751 to $523,050
|$523,051 or more
Long-Term Capital Gains Tax Rates for the Year 2022
If you still need to file for the year 2022, the following capital gains tax rates apply to assets sold for a profit in 2022. Capital gains are reported on Schedule D, which is due with your tax return(Form 1040) by the deadline of October 16, 2023, with an extension.
|0% tax rate
|15% tax rate
|20% tax rate
|$0 to $41,675.
|$41,676 to $459,750.
|$459,751 or more.
|Married, filing jointly
|$0 to $83,350.
|$83,351 to $517,200.
|$517,201 or more.
|Married, filing separately
|$0 to $41,675.
|$41,676 to $258,600.
|$258,601 or more.
|Head of household
|$0 to $55,800.
|$55,801 to $488,500.
|$488,501 or more.
Tax Rules and Considerations for Capital Gains Tax
Besides your income and holding time, there are some other notable factors that come into play in determining capital gains tax.
While the above-mentioned table depicts capital gains tax rates applied mostly on assets, there are also some exceptions. Long-term capital gains tax on ‘Collectable Assets’ can be taxed at a maximum of 28%. Collectible assets include valuables like coins, antiques, precious metals, and fine art. However, short-term gains on such assets are taxed at the ordinary income tax rate.
Net Investment Income Tax
If you have a high income, you may be subjected to net investment income tax. You may owe an additional 3.8% of either your net investment income or the amount by which your gross income exceeds the amounts listed below. The amount which is smaller will be applied.
- Single or Head of Household: $200,000.
- Married, filing jointly: $250,000.
- Married, filing separately: $125,000.
- Qualifying widow(er) with dependent child: $250,000.
Owner-Occupied Real Estate
If you are selling your principal residence, a different standard will be applied to real estate capital gains. $250,000 of an individual’s capital gains on the sale of a home is excluded from the taxable income. If you are married and filing jointly, $500,000 is excluded.
This standard applies as long as the seller has owned and lived in the residence for two years or more. However, capital losses from the sale of a personal property like a home are not deductible from capital gains.
You can also include the cost of significant repairs and renovations of the home to be excluded, further reducing the amount of taxable capital gain.
For example- If you purchase a house for $150,000 and later sell it for $500,000, making a profit of $350,000 on the sale. After applying the exemption of $250,000, you must report a capital gain of $100,000, which will be the amount subject to capital gains tax.
Investment Real Estate
Investors who own real estate are often allowed to take deductions of depreciation to reflect the deterioration of the property as it ages. This only depicts the decline of the property’s physical condition and is unrelated to its changing value in the market.
The deduction of depreciation reduces the amount you have paid for the property in the first place. This can increase your taxable capital gain if you sell the property because the gap between the property’s value after deductions and the sale price will be greater. In most cases, the tax rate that applies to the recaptured amount is 25%
For example- If you claim depreciation of $5,000 and have a capital gain of $15,000 from the sale of the property, the $5,000 depreciation amount will be treated as a recapture of the deduction from income and will be taxed at 25%. Meanwhile, the remaining $10,000 of capital gains will be taxed at the usual amount of 0%, 15%, or 20%, depending on your income.
How to Avoid or Minimize Capital Gains Taxes?
Here are some strategies that can help you avoid or minimize capital gains tax
Hold On to Assets
If possible, you should always hold on to an asset for at least a year or longer so you qualify for the long-term capital gains tax rates. It is significantly lower than short-term capital gains tax and can help you save a lot of your hard-earned money. You can also use the Calculator tool on our website to see how much you can save.
Use tax-advantaged Accounts
There are various types of accounts that are tax-exempted. These include 401(k), individual retirement accounts, or 529 college savings accounts, where investments grow tax-deferred. This means that you don’t have to pay capital gains tax if you sell investments within these accounts.
Roth IRAs and 529 accounts are the best options as they offer huge tax benefits. These accounts offer qualified distributions which means you don’t have to pay taxes on investment earnings. In traditional IRAs and 401(k) accounts, you have to pay taxes when you withdraw funds at the time of retirement.
Rebalance with Dividends
Instead of reinvesting your dividends in the same investments that paid them, you can rebalance by putting that money into underperforming investments. You can do that by selling securities that are doing well and investing that money into investments that are underperforming. Using dividends to invest in underperforming investments will allow you to avoid strong sellers, avoiding capital gains that may come from their sale.
Exclude Home Sales
You must own a home and use it as your principal residence for at least two years to qualify. Also, you must not have excluded another home from capital gains in the two-year period before the sale of the home. If you meet these requirements, you can exclude up to $250,000 in capital gains from home sales if you are single and up to $500,000 if you are married, filing jointly.
Carry Losses Over
The IRS taxes your net capital gain. Your net capital gain is determined by your total capital gains(investments and assets sold for a profit) minus your total capital losses(investments and assets sold at a loss). This means that you can use capital losses to counterbalance capital gains. If your net capital loss exceeds your net capital profits, you can offset up to $3000 of your ordinary income. Any additional losses can be carried forward to future years to counteract capital gains or up to $3000 of ordinary income per year.
For example, if you sold an asset for a $10,000 profit this year and sold another for a loss of $5000, you will be taxed on the capital gains of $5000.
Consult a Robo-Advisor
Robo-advisor is an online application that manages your investments automatically and employs smart strategies to save tax. One of the most common strategies is tax harvesting, which involves selling underperforming investments to offset the gain from those that are doing good.
Capital gains taxes are levied on earnings made from the sale of stocks or investments in a year. The capital gains tax rate is determined based on the holding term and the taxpayer’s tax bracket. It is determined by splitting the difference between an asset’s selling price and acquisition price, which is subjected to different rates. Capital gains tax can sometimes be too complex to estimate. Besides that, there are also hidden charges in the form of cess fees and surcharges.
Lastly, If you are looking to save tax, it is better to have long-term holdings instead of short-term holdings as you have to pay 15% capital gains tax on short-term holdings.
Frequently Asked Questions(FAQs)
Ans. In most cases, you must pay the tax amount after you sell an asset or investment. It is due in the subsequent year’s tax return. For example, if you sell a capital asset in 2022, the capital gains taxes are due for your annual tax return filing for 2022, which is due in April 2023.
Ans. One of the best ways to minimize capital tax is to hold an investment or asset for more than a year. If you want to avoid the tax charge altogether, you can consider holding your assets inside a tax-exempted account like 401(k) or IRA. Investment earnings in these accounts are not taxable until you take distributions at the time of retirement. Moreover, if you have a Roth IRA account, your investment earnings are not taxed at all, provided you follow the guidelines of the Roth IRA.
Ans. Yes, capital gains tax applies to all capital assets including cryptocurrency. Other examples of capital assets include stocks, bonds, mutual funds, real estate, and vehicles.