If you’ve never heard of it before, there is such a thing as capital gains tax. It is a separate tax from other types of taxes like sales tax, property tax, payroll tax, and income tax. Capital gains tax specifically affects people that work with investment assets.
Sounds clear as mud, right? Stay with us, and you’ll see that it’s not nearly as complicated as it might seem. You will also learn how to avoid capital gains tax or deal with it if you can’t avoid paying the necessary taxes.
First, The Basics Of Capital Gains Tax
Capital gains tax rates can be extremely high with rates as much as nearly 40% of the capital gains, so it is no wonder that people want to avoid the tax if possible. Before we get into that, let’s start by getting into what capital gains are and how the tax rate is applied.
What Are Capital Gains?
We begin by setting the stage with this simple scenario. Imagine buying a car that you paid $$ for. It may have been a fixer-upper or a classic car that needed some TLC. You undergo the improvements and pay another $ in repairs making the total money that you have put out a full $$$ for this car.
You decide that same year that you’re going to sell the car and ask $$$ for the sale price which is $$ more than you have in the vehicle. If you sell the car at your asking price, then your capital gain is $$ in that single transaction. That money is taxable under capital gains tax law.
The situation is similar with stocks that are sold in less than a year for short-term gains as well as long-term gains. The only difference is that if you have capital gains as a result of selling stock and then take those gains and invest them into an IRA or a 401k, you won’t have to pay taxes right away.
What Are Capital Gains Tax Rates?
There are a couple of different categories that capital gains fall into – short-term and long-term. Short-term gains are a result of assets that are in your possession for less than a year from the time of acquisition. Long-term gains are assets that you have had for a year or longer.
Short-term gains are typically taxed the same way your income is taxed depending on your total taxable income. If you have less taxable income, your tax rate goes down or vice versa, with the tax rate topping out at almost 40%. The car in the above scenario would have been considered short-term capital gains.
Long-term gains would be reflected in a transaction that happens to an asset that you have had for a year or longer. To give you an example of how that would work, imagine that you purchased stock several years ago for a set price. You decided to sell that stock and the resulting difference is $10,000 in capital gains. Because you owned the stock for longer than a year, you qualify for a lower tax rate.
How Are Capital Gains Taxed?
Capital gains are taxed according to your taxable income. That means that the taxes you can expect to pay are a reflection of the tax bracket that you fall into according to the IRS.
As per the Tax Policy Center, “Taxpayers in the 10 and 15 percent tax bracket pay no tax on long-term gains on most assets; taxpayers in the 25-, 28-, 33-, or 35- percent income tax brackets face a 15 percent rate on long-term capital gains. For those in the top 39.6 percent bracket for ordinary income, the rate is 20 percent.”
The numbers are important to recognize because depending on which tax bracket you fall into, you may very well not have to pay capital gains tax on long-term gains. For reduced tax rates, you want to sell your assets after you have owned them for a year.
As stated earlier, short-term gains are taxed as ordinary income with a 3.8% tax on investment income if your income is more than $ as a single taxpayer or $$ for married filing jointly. Investment income includes things like dividends that are issued to stockholders.
Do You Pay Capital Gains Tax When You Sell Your Home?
The good news for homeowners that are looking to sell their homes is that in most situations, your home sale is exempt from capital gains tax laws. There are specific conditions that you have to meet to exclude any capital gains from being taxed when it comes to selling your home.
First, you have to own your home for a minimum of two years in the previous five years leading up to the sale. Your home also has to have been your primary residence for a minimum of two years during that same five-year time frame. You also can’t have sold another home during the previous two years and excluded that gain to avoid the tax.
Full stop that means that you can’t use a rental property that you’re selling as an asset that you can claim an exemption on unless you lived there previously. If you’re investing in a rental property that you have no intention of living in, and then you sell it, there is no avoiding that capital gains tax. The only exception, known as a 1031 exchange, is if you roll the proceeds into a similar investment within six months of the sale date.
How Can You Offset Capital Gains?
Capital losses are one of the keys here when it comes to learning how to avoid capital gains tax. Capital losses can offset your capital gains because things that go up must come down. This especially applies to investors when you consider the way stocks can play against each other.
Imagine that you’ve received $$$ in long-term gains as a result of selling a stock. You also sold another stock but have $$ in losses from that sale. That means that the only amount that you can expect to pay capital gains taxes is on the $ difference between the gains and losses as a result of selling both stocks in the same calendar year.
On the other hand, capital losses can roll forward into another year if they’re over $ in a calendar year. In other words, if you sell a stock that results in $$$ in losses, and you sell another stock that results in $$ in gains, you can match losses for that year.
The remaining $$ can be rolled over into losses for the next year and every year provided that the losses that continue to roll over are more than $ each calendar year. For investors, this is a key approach when it comes to how to avoid capital gains tax.
A Few Last Tips On How To Avoid Capital Gains Tax
There are a few other ways to avoid paying some of the tax if not all of the tax. It depends on your circumstances and what you’re willing to do.
As an example, you can also sell when your total taxable income is low. Having a lower income means your capital gains tax is also decreased. Choosing to sell long-term assets when your income is lower is fiscally smart because it saves you money.
Reduce your taxable income where you can, too. That means you need to get as many credits and deductions as possible prior to filing your income tax return. Credits and deductions include donations to non-profit organizations, IRA or 401k contributions, or even otherwise expensive medical procedures that need to be done. Dental work, anyone?
Savvy Investors And Capital Gains Taxes
There are many different ways when it comes to how to avoid capital gains tax. Savvy investors know the loopholes and work to keep as much of their income as possible, but don’t misunderstand that it is easy to do.
Sure, there are certain approaches that are easier like selling low-performing stocks or claiming the primary residence exclusion, but there are many other complex approaches, too. Take the time to research ways to avoid the tax and learn all you can. After all, you earned your money, and you deserve to keep it.