Editors Note:
Capital gains tax, which applies to many investment transactions, is an important component of the investment landscape, affecting millions of investors.
From stocks and bonds to real estate and cryptocurrencies, understanding how capital gains are taxed is essential for making informed investment decisions and optimizing tax liability.
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In this comprehensive guide, attorney Orla O’Connor delves into the intricacies of capital gains tax, exploring whether you had a capital gain, when it is taxed, how it is calculated, and what capital gains tax rates apply. This article also identifies IRS reporting requirements for capital gains and provides tips for taking advantage of preferential capital gains tax rates.
Whether you're a seasoned investor or just starting, mastering the ins and outs of capital gains tax can help avoid costly mistakes.
[This is not a substitute for sound professional advice but can help investors understand the general capital gains tax framework and identify areas where professional help is needed.]
Read on.
Capital Gains Tax Defined
What is a capital gain?
A capital gain is the profit you make from selling or trading a "capital asset." With certain exceptions, a capital asset is generally any property you hold, including:
- Investment property, such as stocks, bonds, cryptocurrency, real estate, and collectibles; and
- Property held for personal use, such as a car, house, or home furnishings.
There are, however, various special rules that may affect your property's classification or treatment as a capital asset. In that case, the way you report the transaction and calculate your taxes due will differ.
For instance, if you sell frequently to customers, the property you sell might not be treated as a capital asset. Instead, it may be considered business inventory, and profits from the sale of inventory aren't taxed as capital gains.
So, watch out if you sell too many Gucci handbags or real estate investment properties, as these may be treated as inventory, and the tax on any gains will be at the higher ordinary income tax rates. Similarly, if you sell or exchange depreciable property to a related person, your gains will be taxed as ordinary income.
In addition, intellectual property (e.g., a patent; invention; model or design; secret formula or process; copyright; literary, musical, or artistic composition; letter or memorandum, etc.) is not considered a capital asset if it's held by the person who created it or, in the case of a letter, memorandum or similar property, the person for whom it was prepared or produced.
Plus, although real or depreciable property used in a trade or business is not a capital asset, gains from the sale or involuntary conversion of them may nonetheless be treated as capital gains if they were held for more than one year. So, for all practical purposes, this type of business property is treated as if it was a capital asset.
How Capital Gains Are Taxed
When are capital gains taxed?
Capital gains are taxed in the taxable year they are "realized." Your capital gain (or loss) is generally realized for tax purposes when you sell a capital asset. As a result, capital assets can continue to appreciate (increase in value) without becoming subject to tax as long as you continue to hold on to them.
For example, loans against your capital asset don't give rise to a realization event or capital gains tax. For this reason, many real estate investors will refinance properties rather than sell them.
Other events besides sales can also give rise to a "realization." For instance, property that is involuntarily converted or taken by the government, or over which you grant an exclusive use right to others, may be treated as sold.
A capital gain (or loss) is also realized when the property is exchanged for other property. Accordingly, when preparing your tax return, you should consider whether you were party to any nonstandard transactions of this type during the tax year.
Special rules apply to certain "like-kind" exchanges of real estate. For instance, you generally need to identify replacement property within 45 days. So, unless you disposed of a property very close to the end of the tax year, you likely will be too late to defer your gains using a like-kind exchange.
On the other hand, the "qualified opportunity zone" program, which allows you to defer capital gains by making a qualifying investment in designated economically distressed communities, generally has more generous timing rules. With a QOZ, you have 180 days to take action to defer your capital gains.
Calculating Taxable Gain
How to calculate capital gain tax
Your taxable capital gain is generally equal to the value that you receive when you sell or exchange a capital asset minus your "basis" in the asset. Your basis is generally what you paid for the asset. Sometimes this is an easy calculation – if you paid $10 for stock and sold it for $100, your capital gain is $90. But in other situations, determining your basis can be more complicated.
Tax Tip: Since your basis is subtracted from the amount you receive when disposing of a capital asset, you want the highest basis possible so that the taxable portion of your profit is as low as possible. Sometimes this is a matter of substantiating your basis, which requires good recordkeeping.
If you sell some but not all of the stock you hold in a company, and you acquired stock on different dates, there are several ways to determine your basis. Usually, the first-in-first-out rule applies (i.e., stock you purchased first is considered sold before stock you purchased later).
However, the basis might instead be determined by specific identification and matching of each share you bought and sold. You may also elect to use the last-in-first-out rule (i.e., stock you purchased last is considered sold before stock you purchased earlier) or the average cost basis for all shares sold. Given these differences, if you acquired the stock on different dates (e.g., through a dividend reinvestment plan), make sure you pay close attention to your method of accounting before selling down your position.
Basis calculations are also more complicated if you acquired the capital asset you're selling other than by an ordinary purchase.
- For example, if you inherit an asset, you generally take a "stepped-up" basis (i.e., the asset's fair market value at the date of the previous owner's death).
- If someone gives you a capital asset as a gift, the donor's basis carries over to you.
- If you receive stock from your employer as part of your compensation, your basis is generally equal to the amount included in your taxable pay (i.e., reported on your Form W-2) allocated to the securities.
Your basis can also include more than simply your initial purchase price. For example, your basis can also include expenses related to buying, selling, producing, or improving your capital asset that is not currently deductible. This will reduce your gain when you sell.
Note: Home improvement expenses and brokers' fees and commissions clearly identified with a particular asset can raise your basis. Just make sure you keep receipts and other records related to these additional costs. Also, note that certain investment-related expenses are miscellaneous itemized expenses and disallowed through 2025 (nor will these expenses increase your basis).
The amount of capital gain subject to tax can also be reduced if an exclusion applies. Perhaps the best-known capital gains tax exclusion is for the first $250,000 of gain ($500,000 if filing jointly) from the sale of a personal residence you've owned and lived in for two of the last five years.
In addition, 100% of your gain from the sale of "qualified small business stock" may also be excluded if you acquired the stock after September 27, 2010. If the stock was purchased before that date, you may be eligible for a partial exclusion of 50% or 75% of the gain.
Various other actions can impact your basis or the calculation of capital gain. These include, among other things, granting an easement over land you own, taking depreciation deductions for wear and tear on your property, or selling property for less than fair market value (i.e., a "bargain sale"). When more complicated situations like these arise, it's best to seek a tax professional's advice before selling or exchanging the related capital asset.
Tax Rates for Capital Gains
Capital gains tax rates
Long-term capital gains are subject to lower rates of tax than short-term capital gains, which are taxed at ordinary income tax rates. You therefore need to know your holding period for any capital asset you sell. If you hold an asset for more than one year, the gain you realize when you sell it will be long-term capital gain and taxed at reduced rates.
If you sell some but not all your stock in a company, the rules for determining your holding period will depend on your method of accounting for the securities (e.g., FIFO, LIFO, etc., as noted above in relation to determining your basis). You also may get to count the holding period of the person from whom you acquired your stock if you acquired it other than by purchase or other taxable transaction (e.g. if you inherited it).
If you have long-term gains, the next thing you need to know is which capital gains tax bracket you fall into – the 0%, 15%, or 20% bracket. Just like with your wages and other ordinary income, the rate at which you're taxed on long-term capital gains depends on whether your taxable income is above or below certain thresholds for the year. Unlike federal tax brackets for ordinary income, once your total income is above the relevant threshold, all of your capital gains are taxed at the higher rate (so there may be situations where you may come out ahead by earning less total income for the year).
For the 2024 tax year, the 0% rate applies to people with taxable incomes up to $94,050 for joint filers, $63,000 for head-of-household filers, and $47,025 for single filers and married couples filing separate returns.
- The 15% rate applies to people with taxable incomes above these limits and up to $583,750 for joint filers, $551,350 for head-of-household filers, $492,300 for single filers, and $291,850 for married couples filing separate returns.
- If your taxable income is above the 15% bracket, you will pay tax on your capital gains at 20%.
- The thresholds for each tax rate are adjusted annually for inflation, so the limits are different for 2024 than for 2023.
For more information, see: What Are the Capital Gains Tax Rates for 2024?
Special capital gains tax rates apply when certain assets are sold. For example, any gain from the sale of qualified small business stock that isn't excluded is subject to a special capital gains tax rate of 28%. A special 25% rate also applies to unrecaptured Section 1250 gain.
This is generally the amount of depreciation previously taken on real property, but it can't exceed the amount of gain you realize from the sale of the property. In addition, gains from the sale of collectibles are taxed at 28%. This includes gains from the sale of art, antiques, stamps, coins, gold or other precious metals, gems, historic objects, or other similar items.
Note, however, that the special rates are maximum rates for people with higher incomes. If your ordinary tax rate is lower than the special rate (i.e., either 10%, 12%, 22% or 24%), your ordinary tax rate may apply to gain on qualified small business stock, Section 1250 gain, or collectibles.
Caution: In addition to the capital gains tax, there is also a surtax that applies to "net investment income." (NII includes, among other things, taxable interest, dividends, gains, passive rents, annuities, and royalties.)
If your income is above a certain threshold – $200,000 if single, $250,000 if filing jointly, or $125,000 if married filing a separate return – you generally must pay the additional 3.8% surtax on your capital gains. However, this surtax doesn't apply to capital gains resulting from the sale of business assets if you're an active participant or real estate professional.
Understanding Capital Losses
What qualifies as a capital loss?
What if you have an overall net capital loss? Up to $3,000 per year in capital losses ($1,500 if married filing separately) can be used to offset ordinary income (such as wages) in computing your tax liability. You can also carry forward any unused capital losses (i.e., above $3,000) to future tax years until they are used up. But, unfortunately, you can't carry back your capital losses to prior tax years.
If you have a capital loss on a sale of securities, pay attention to the "wash sale" rule.
- This rule prevents you from offsetting gain with a loss on securities you sold if you repurchase the same or substantially identical securities within 30 days before or after your sale.
- It also applies across your brokerage accounts, so if your investment advisor sells stock of a company at a loss in one of your accounts and you buy the same stock within 30 days in another account, your loss is still disallowed.
- As a result, if you sold assets at a loss toward the end of 2023, make sure you do not acquire substantially similar securities before 30 days have elapsed.
In addition, losses on the sale or exchange of personal use property are deductible only in very rare circumstances. A deduction is currently only allowed as a personal casualty loss arising from a federally declared disaster, and even then, it's only allowed to the extent the loss exceeds $100 per casualty and 10% of adjusted gross income (AGI).
As a result, as many homeowners who are forced to sell during a financial crisis learn the hard way, you can't harvest a loss on your personal residence. Of course, these restrictions also prevent you from taking a capital loss on a Gucci handbag that you bought at a fancy store and later sold for a fraction of the original price — even though you would need to report the capital gain if you made a profit on that sale. So, when it comes to paying federal taxes, sometimes there's a bit of "heads they win, tails you lose."
How to Report Capital Gains
Reporting capital gains tax on your return
Whenever you file your annual federal tax return, you have to complete some additional forms if you had a capital gain or loss last year.
- Report your transactions giving rise to capital gain or loss on Form 8949.
- This includes capital gains and losses you earn through investments in mutual funds and other investment vehicles, as reported on 1099 or K-1 forms. Attach Form 8949 to your return.
- Calculate your net capital gain or loss and report capital loss carryforwards from any prior year on Schedule D. You also must attach Schedule D to your Form 1040.
- Use Form 4797 to report the sale of depreciable property used in your trade or business (including real estate owned for investment) and depreciation recapture.
You also may be required to pay estimated taxes on capital gains. Generally, you must pay 90% of your current year's taxes, or an amount equal to 100% of your taxes from the prior year (110% if your AGI was more than $150,000), either through withholding or estimated tax payments.
If you did not pay estimated taxes on your capital gains throughout the year, you may be required to pay a penalty when you file your tax return. If you extend the filing of your federal income tax return, you should generally take this into account when making your extension payments.
State Capital Gains Taxes
State and local taxes on capital gains
Don't forget to consider state and local income taxes when you sell a capital asset. Some states and municipalities tax capital gains and others don't. Whether or not you must pay capital gains tax in a particular state depends not only on where you live but also on the type of asset you're selling.
For example, if you sell real estate, the relevant taxing state is generally the location of the property. However, if you sell stock, it's your state of residence.
If your capital gain is subject to tax in a state other than where you live, find out if that state will also tax the gain. If so, your state of residence may grant you a credit for any taxes paid to the other state.
Check with the state tax agency where you live to learn more about how your state taxes capital gains.
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