Everybody you know is now investing. Stocks like Tesla & Amazon going through the roof and the real estate market is at an all time high. You know that you should invest in stocks and real estate for retirement, but what does that mean for your taxes? How does capital gains tax work? How do you pay the least amount of tax?
Capital Gains and Capital Assets
Capital gains are special tax rates based on the sale of a Capital Asset. The most common one you here about is the 15% long term capital gain tax on stock you hold for over a year. However, there are multiple types of Capital Gains rates base on different factors. We will go over them below.
What is a Capital Asset?
It is an asset that an individual owns, such as Stocks, Bonds, Real Estate, Collectible Art, Gold Coins, etc.
Types of Capital Gains
There are two mains types of Capital Gains – Short Term and Long Term. In order to find out how much tax you’re going to pay there are four factors you need to know:
- holding period,
- taxable income,
- filing status, and
- if there is a special rule.
Below is a simple chart regarding the rates and holding periods. As you see below, you always want the long term, since you will pay the least amount of tax!
| TYPES OF CAPITAL GAINS |
|---|
| TYPE OF GAIN | TAX RATE | HOLDING PERIOD |
|---|---|---|
| Short Term Capital Gains | Up to 37% | < 1 Year |
| Long Term Capital Gains | 0%, 15%, 20%, 25%, or 28% | > 1 year |
Long Term Capital Gains
As mentioned above, you want Long Term capital gains, not short term. So most people try and hold their capital assets for over a year, so they will pay tax at a lower tax rate. However, within Long Term capital gains there are multiple rates. The most common ones are 0%, 15% or 20%. These are based on your filing status (married, single, etc.) and taxable income for the year. Below is a simple chart breaking it down for you.
| LONG TERM CAPITAL GAINS – TAXABLE INCOME |
|---|
| TAX RATE | SINGLE | MARRIED | HEAD OF HOUSEHOLD |
|---|---|---|---|
| 0% Rate* | $0 to $40,400 | $0 to $80,800 | $0 to $54,100 |
| 15% Rate | $40,401 to $445,850 | $80,401 to $501,600 | $54,101 to $473,750 |
| 20% Rate | > $445,850 | > $501,600 | > $473,750 |
*Technical speak for CPAs and Tax Aficionados: Your long term capital gain tax rate is based on your taxable income. The 0% tax rate is applied to taxpayers whose gains fall within the lower brackets of taxable income. However, since the ordinary gains are taxed at different rates, the IRS applies ordinary income to the bottom brackets first and then applies the long term capital gains after (i.e. if your ordinary income is greater than the top of a LTCG bracket, your Long Term Capital Gains will be pushed into the next higher rate).
Special Rates for Collectibles and Depreciation
If your Capital Assets falls under a special rule, your tax rate may be different. The two most common ones are Recapture of Depreciation (e.g. depreciation taken on a rental property as a deduction) or tax on sale of a collectible, such as gold or artwork. Here is a helpful chart.
| RATE | TAX TYPE | SPECIAL RULE / EXCEPTION |
|---|---|---|
| 25% | Depreciation Recapture | Depreciation recaptured on the sale of capital assets (e.g. rental properties) have a special tax rate of 25%. |
| 28% | Collectibles | Collectible assets, such as coins, precious metals, antiques, and fine arts have a special long term capital rate of 28%. IRS has said that ETFs and Mutual funds that hold these collectibles, such as a Gold ETF, are also subject to the 28% rate. |
Losses on Capital Assets
Losses on Capital Assets are treated differently than gains. Even though you have to pay tax on all the gains you make in a year, you can only deduct up to $3,000 of net losses. You don’t loses those losses entirely, they will have to be carried forward into the next year. Below is an example of how the losses work.
Example:
In year 1 you sell stocks for a gain of $10,000, you will have pay tax on all of it.
In year 2 you sell stocks for a loss of $15,000, you will get to deduct $3,000 and carry forward $12,000 of losses.
In year 3 you sell stocks for another gain of $5,000, you can offset your $12,000 carry forward losses against it and pay no tax. You will still get to deduct $3,000, and have a carry forward of $4,000.
In year 4 you sell stocks for another gain of $10,000, you will only pay tax on $6,000 since you can use up the remaining $4,000 of carry forward losses.
If you have a lot of capital losses, you may considering talking to your financial planner about Lost Harvesting.
Capital gains can be complicated for those of us that don’t know what tax bracket we fall into. If you are going to make a large sale of stocks or real estate, we recommend you check with your CPA to make sure that you understand the taxes you will owe.