A capital gains tax is classified as the tax earned from the growth in an investment’s value. However, this tax is only incurred when individuals or corporations sell these investments. When such assets are sold, the capital gains are seen as being ‘realized.’
Hence, tax isn’t applied to ‘unrealized capital gains’ or unsold investments. It doesn’t matter how long you hold an investment for, stock shares that appreciate each year aren’t subject to capital gains taxes until these assets are sold.
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Long-Term and Short-Term Capital Gains Tax
Day traders and other individuals taking advantage of online trading activities need to understand that any profits made from buying and selling assets are taxed at a higher rate when being held for less than a year. Short-term capital gains tax only applies to assets held for one year or less.
The profit gained from selling an investment held for less than one year is taxed as ordinary income. In contrast, profits from the sale of assets held for more than one year are called long-term capital gains and have rates varying from zero percent to 20 percent, depending on the individual’s tax bracket.
Taxable capital gains for a year are compared against the number of capital losses incurred in the same year. A capital loss is incurred when you sell an investment for less than you bought it for. The total of your long-term capital gains less any capital losses incurred in the same year is called the ‘net capital gain.’ This is the amount capital gains taxes are calculated from.
How Are Capital Gain Tax Rates Calculated?
Profits on the sale of an asset are typically treated as a salary or wages for tax purposes when owned for less than one year. Thus, you’re taxed on your short-term capital gain at the same rate as your regular earnings. However, one exception is if this gain pushes you into a higher marginal tax bracket.
This taxation system also applies to dividends gained from an asset, which is recognized as a profit although it’s not a capital gain. Dividends earned in a year are taxed as ordinary income for taxpayers in the 15 percent and higher tax bracket.
Nonetheless, a different taxation system applies for long-term capital gains. The tax paid when long-term assets are sold for a profit varies for each individual and is based on income thresholds. Some of these factors include the tax bracket you’re in and your filing status. Overall, the tax rates applied to long-term capital gains are known for being lower than ordinary income tax rates.
Special Capital Gains Rates and Exceptions
There are some exceptions when working across different asset categories. These are:
Owner-Occupied Real Estate
Capital gains involving real estate are taxed under an alternative standard if you’re selling your principal property. When calculating this owner-occupied real estate tax, $250,000 of a taxpayer’s capital gains received from the sale of a house are excluded from taxable income. This amount is $500,000 for taxpayers who are married and filing jointly.
Such taxation only applies if the seller has owned and lived in this house for two years or more. Nonetheless, capital losses from the sale of personal property, like a house, aren’t deductible from these gains.
Investment Real Estate
Investors owning real estate are allowed to take depreciation deductions into account when calculating the income realized from the sale of such property. This is done to reflect the deterioration of this investment as time goes on. Such depreciation in a home’s value isn’t related to possible appreciation in the entire property’s value. Additionally, the real estate market isn’t considered when making these calculations.
This accumulated depreciation reduces the amount you initially paid for the property. Thus, it can boost your taxable capital gain if you sell this real estate. That’s because the difference is greater between the sale price and the property’s value after these depreciation deductions are applied.
Capital gains on the sale of collectibles, like precious metals, jewelry, antiques, art, and stamp collections are typically taxed at a rate of 28 percent. This is regardless of an individual’s income. Thus, you’re going to be levied at this higher tax rate if your tax bracket is lower than 28 percent. In contrast, your capital gains taxes are going to be limited to this 28 percent rate if you’re in a higher tax bracket.
Taxpayers might be subject to a levy if their income is greater than the set maximum, which is the net investment income tax. Such tax imposes an extra 3.8 percent of taxations on your investment income, which includes capital gains. However, this net investment income tax is only applied if your modified adjusted gross income exceeds specific maximums.
It’s important to understand that this modified adjusted gross income isn’t your taxable income. Such threshold amounts are $125,000 if you’re married and filing separately, $200,000 if you’re the head of the household or single, $250,000 if you’re a surviving spouse or married and filing jointly.
Legally Reducing or Eliminating Net Capital Gains
As we have mentioned, tax on capital gains reduces the overall return generated from the sale of an investment. However, legitimate methods are available for some investors to reduce or eliminate their net capital gains for a year.
One of the most straightforward strategies of reducing net capital gains is to hold assets for more than one year before making a sale. This is because, as we have previously mentioned, the tax you pay on long-term capital gains is significantly lower than the tax applied to short-term gains. Additionally, capital losses can be brought forward to subsequent years to reduce any future income while decreasing a taxpayer’s tax burden
Nonetheless, you also have other strategies to lower your net capital gains, like:
- Using tax-advantaged retirement plans, like Roth IRAs and 401 (k)s
- Using any excess in capital losses in alternative ways
- Considering when you’re going to retire
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