The Dilemma of Capital Gains Tax: A Comprehensive Guide

When you sell a stock or mutual fund that you’ve owned for more than one year, any profit on the sale is considered a capital gain. Capital gains tax rates depend on how long you own the investment and your specific income bracket. Even if capital gains are usually lower than ordinary income taxes, an unexpected capital gains tax can be a double whammy for high-income taxpayers. Capital gains taxes are usually lower than ordinary income taxes, but an unexpected capital gains tax can be a double whammy for high-income taxpayers. For example, if you own stock that has increased in value and you sell it, you have a capital gain. However, if you owned the stock for less than a year, you will have to pay the same rate as your ordinary income taxes on the profits. If you owned the stock for more than a year but less than two years, you will pay a 15% capital gains rate. If you owned the stock for more than two years, you will pay a reduced rate, but not less than 10%.

There are two primary reasons people pay capital gains tax: because we have them and because they’re cheap to collect. Because there’s no way to track the cost basis or original purchase price of every security traded, the IRS has to rely on self-reporting to collect capital gains taxes. This makes capital gains a non-recurring, unanticipated source of revenue for Uncle Sam. Fortunately, many strategies can help you avoid or minimize paying capital gains taxes.

What are the rules for Capital Gains Tax?

There are two primary rules to know when it comes to capital gains taxes. First, capital gains are taxed differently than ordinary income. They are taxed at different rates and there are different rules around when they’re due.

Second, capital gains are calculated based on the cost basis of the investment. When you buy stocks or other investments, you’re buying shares from someone else. When you decide to sell your shares, you can either try to find another buyer or you can attempt to sell your shares back to the company. The company you sold your shares to will likely have a holding period before you can sell your shares back to them. This term is how long the company has to wait before it can buy back its shares. Usually, this period is 90 to 180 days, but it can be longer. Holding periods are not required by regulation, but most companies choose to have them. Holding periods are standard among investors and can be beneficial to both the company and the investor. It’s their shares that will be sold when you decide to sell those stocks or mutual funds. The person selling their shares will report the price they sold them for (the capital gains) as well as the cost basis. The cost basis is the original price you paid for the shares. This determines the number of your capital gains.

Long-term and Short-term Capital Gains

The duration of ownership determines the tax rate you’ll pay on the sale of an investment. Capital gains are generally categorized as either short-term or long-term gains. Long-term capital gains are the capital gains on investments you’ve owned for one year or more. Short-term capital gains are on investments you’ve owned for less than one year. Short-term capital gains are the capital gains on investments you’ve owned for less than one year. The tax rate on long-term capital gains is usually lower than the rate on short-term capital gains. Long-term capital gains are usually taxed at a rate of 15%–20%, while short-term capital gains are taxed at your ordinary income tax rate, which in 2018 ranges from 10% to 39.6%. In certain situations, long-term capital gains may be tax-free. For example, if your taxable income is less than $38,600 (if you’re single) or $77,200 (if you’re married filing jointly) in 2018, you may be exempt from paying taxes on your long-term capital gains.

The specific capital gains tax rates depend on your income bracket. The table below shows the capital gains tax rates and brackets based on filing status. Keep in mind that these tax brackets and capital gains tax rates aren’t set in stone and are subject to change each year. If you’re married and filing jointly, the capital gains tax rates and brackets are the same for both spouses.

Which Investments Produce Capital Gains?

Almost any investment you own can produce capital gains. Stocks, mutual funds, and exchange-traded funds (ETFs) are the most common capital gain-producing investments.

When you sell a stock or mutual fund, you’re selling part ownership in the company that issued the stock or created the mutual fund. When you sell, the company will report the amount of profit you made on the sale as a capital gain. Real estate transactions also generate capital gains. When you sell a piece of property like your home, the amount you exceed your original purchase price is a capital gain.

Your investment income, such as interest and dividends, are not taxed as capital gains. They are taxed as ordinary income.

Exceptions to the Rule: When You Don’t Pay Capital Gains Tax

There are certain situations when you don’t have to pay capital gains taxes or you can deduct the capital gains taxes from your income.

If you have a loss: If you have a capital loss you can use that loss to offset any capital gains you’ve had in the same year. In other words, you don’t pay tax on your loss until you’ve used it to offset other capital gains.

If you sell your home: If you sell your home and you’ve lived in it as your primary residence for at least two years out of the last five years, you don’t pay any capital gains tax on the profit from the sale.

If you’re un- or under-employed: If you’re unemployed or underemployed and you’re collecting social security, you can use those benefits as a source of income when calculating your capital gains. If you receive unemployment benefits, you don’t have to pay capital gains on those benefits.

Strategies to Avoid or Minimize Paying Capital Gains Tax

There are a few strategies you can use to avoid or minimize paying capital gains taxes. You can:

Sell winning investments: If you’ve had a winning investment for a long time, it’s likely to be taxed at a higher rate when you sell it. To avoid these higher rates, you can sell an investment that’s done well. You’ll pay a lower rate on the capital gains and it’ll offset the amount you owe on the winning investment.

Use tax-loss harvesting: You can use tax-loss harvesting to harvest the loss on an investment and use the loss to offset the capital gains on another investment.

Buy and hold: If you buy and hold an investment for at least a year, the gains will likely be taxed at the lower long-term rate. If you’ve had an investment longer than a year but you think it will go up in value, sell it and buy it back again. This will reset the clock on the holding period and it will be taxed as a long-term gain.

Strategies to Be Aware of When Planning for Capital Gains Taxes

If you have a large amount of capital gains to report in a given year, be aware that the IRS may scrutinize your returns more closely. You can avoid this with a few simple steps:

Spread out your sales: If you have a large number of sales in one year, it may look suspicious. If possible, spread out your sales over a few years to avoid triggering an audit.

Wait until the end of the year: If you have a large number of capital gains, you may want to wait until the end of the year to sell. By waiting until December, you’ll have an additional month to sell investments and report the gains on your tax return.

Bottom line

Capital gains taxes are a significant source of income for the federal government. Be aware of the rules around capital gains and how to minimize or avoid paying the taxes on your gains. With a little planning, you can reduce the amount of capital gains tax you pay. We are all hopefully aware that investing in things like real estate, stocks, and mutual funds is a great way to grow our wealth. What many people don’t know is that when you sell these assets, you might have to pay capital gains tax on the profits you made. Capital gains are taxable profits that you make when selling investments like stocks, property, or other assets. Capital gains taxes are especially important to consider if you’re investing with a Roth IRA, as these are tax-free when you withdraw them in retirement.