In the world of finance, "capital gain" is a synonym for "profit." So understanding capital gains taxes should be a top priority for anyone considering the sale of investment securities and/or real estate assets that have appreciated in value. Because, unlike income taxes, which apply to your paycheck and other earnings, capital gains taxes are levied on the profits you make from selling property such as stock investments or real estate.
However, there are planning strategies available to help you manage capital gains taxes. For example, monitoring your investment holding period (the amount of time you have owned an investment) is important when assessing potential capital gains taxes. Also, offsetting investment gains with investment losses on your tax return could spare you from needing to write a check to Uncle Sam in April.
Long-term capital gains vs. short-term capital gains
A profit is a profit, no matter how long you owned the asset you sold for a gain. However, your holding period will affect the tax treatment of your capital gains. Why? Because long-term capital gains are taxed at a lower rate than short-term capital gains.
Here's how it works:
Capital gains tax math
Depending on the circumstances, determining your capital gains taxes can be fairly easy or quite complicated. For example, if you sell a single asset, such real estate or an individual investment security, the capital gain can be calculated by subtracting your purchase price from your sale price. A quick glance at the calendar will then let you know whether the profit will be treated as a short-term capital gain or a long-term capital gain.
Other scenarios may not be so simple. For example, selling numerous mutual fund shares acquired at different times for different prices will require you to choose one of several IRS-approved accounting methods for calculating your capital gains taxes. Those methods may include identifying the specific shares that were sold, determining the average price of all of the shares or determining the average prices of your short-term shares and long-term shares.
Managing capital gains taxes
The most basic strategy for managing capital gains taxes involves the timing of your sale. If you can wait until you have owned the asset for at least one year before selling it, you'll qualify to pay taxes at the lower long-term capital gains tax rate. Selling before the one-year anniversary of your purchase, however, would subject you to short-term capital gains taxes and could significantly increase your tax bill.
Here's a hypothetical example of how capital gains taxes affected two different investors:
Investor A pays federal income taxes at the highest possible rate: 35%. She decided to sell an appreciated asset but remembered to check the calendar first. She then realized that she had only owned the asset for 11 months. So she waited another month-until she had owned the investment for more than one year-before selling. Consequently, she was required to pay a long-term capital gains tax of only 15%.
Investor B is also in the 35% federal income tax bracket, and he also decided to sell an asset that had appreciated in value since he purchased it. However, he did not check the calendar first and sold the investment after owning it for less than one year. As a result, he paid a short-term capital gains tax of 35%-more than twice as much as he would have paid in long-term capital gains.
Another effective strategy for managing capital gains taxes involves offsetting capital gains with capital losses on your annual tax return. You can only offset up to $3,000 in gains in a single year, but you may be able to carry forward losses in excess of $3,000 in order to offset future gains.
Remember: You may not be able to avoid taxes entirely, but understanding capital gains taxes could prevent you from paying more than necessary to Uncle Sam after the sale of appreciated investment assets or real estate.
You might be able to avoid paying taxes on the sale of a primary residence, and you also have options for reducing the tax burden following the sale of investment real estate.
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