We’re all pretty sure what “profit” means. After all, income is income – isn’t it?
Well, not in the eyes of the Internal Revenue Service (IRS).
The tax people treat different types of income differently, at least as far as tax rates are concerned. This is particularly true when it comes to profits from your investments, or “capital gains” in financial-speak.
In a nutshell: The IRS taxes certain capital gains at a lower rate than other types of investment income. So understanding the ins and outs of capital gains is important for any investor and their investment strategy.
What are capital gains?
Capital gains consist of the money you receive from the sale of capital assets.
The IRS considers almost everything you own, except for property used in a business, to be a capital asset. That can include:
Stocks, bonds, and other investments
Your home or a vacation property
Personal-use items, such as clothing, household furnishings, and jewelry
Collectibles such as coins, stamps, antiques, and artwork
Cars, motorcycles, boats, and other vehicles
Every capital asset has a “basis,” which is typically what you paid for the asset, plus any money you invested towards improving it.
When you sell a capital asset, the difference between the sales price and your basis is either a capital gain (if the sales price is higher than your basis) or a capital loss (if the sales price is lower than your basis).
For example, say you purchase 100 shares of Apple stock (AAPL) for $120 per share. Your basis in the stock is $12,000. You later sell all 100 shares for $145 per share, or $14,500. Your capital gain would be $2,500.
Capital gains tax basics
When you sell a capital asset, the gain (or the loss) is classified as either short-term or long-term, depending on how long you owned the asset prior to the sale date.
If you owned the asset for more than one year, it’s generally a long-term capital gain or loss. If you owned it for one year or less, the gain or loss is short-term.
Why is this significant? Because how long you hold the asset determines the tax rate you pay on your profit — the capital gain.
Short-term capital gains tax rate
In the case of short-term capital gains, it’s a no-brainer. They are taxed just like other ordinary income, such as wages or income from a business or self-employment. Short-term capital gain taxes correspond to ordinary income tax brackets, which range from 10% up to 37%.
Long-term capital gains tax rate
With long-term capital gains, things get more interesting. They qualify for special tax rates. And in most cases, these are lower than the tax bite incurred by your ordinary income and short-term gains.
There are three basic tax rates, and the one that applies depends on your filing status and your total taxable income — not on the size of the capital gain itself. For 2020 and 2021, the long-term capital gains rates are as follows:
The 2020/2021 capital gains tax rates and taxpayer income levels, sorted by filing status. Yuqing Liu/Business Insider
Special capital gains tax rules
The tax rates in the tables above apply to most assets, including most investments. But you should be aware of a few rules and exceptions.
Long-term capital gains on collectibles (such as antiques, coins, stamps, or artwork) are taxed at a rate of 28%.
Capital losses from the sale of personal property aren’t deductible. So if you sell your home or vehicle for less than you paid for it, you cannot claim a deduction.
While they pay 20% in capital gains tax, high-income investors may also owe the Net Investment Income Tax. A separate tariff, it applies an additional 3.8% tax on all investment income, including capital gains. NIIT affects single taxpayers with modified adjusted gross income over $200,000 or married couples filing jointly with modified adjusted gross income over $250,000.
If you inherited a capital asset, your holding period is automatically long-term, no matter when the person who left it to you purchased it.
When you sell your home, you don’t have to pay tax on the first $250,000 of gain from the sale. That exclusion is doubled to $500,000 for married couples filing a joint return. To qualify, you must have owned and used the home as your primary residence for at least two of the last five years.
Calculating capital gains: an example
The capital gains tax rate doesn’t apply on an item-by-item basis but to your overall net capital gains.
Say you are a single taxpayer with the following stock transactions in 2020:
Stock A: long-term capital loss of $4,000
Stock B: long-term capital gain of $7,000
Stock C: short-term capital loss of $5,000
Stock D: short-term capital loss of $3,000
To calculate your net gain or loss, you first need to calculate your long-term and short-term sales, to come up with a net result.
Long-term: ($4,000) + $7,000 = $3,000 gain
Short-term: ($5,000) + $3,000 = $2,000 loss
With a net long-term gain of $3,000 and a net short-term loss of $2,000, you have a net capital gain of $1,000.
Now, let’s assume that your total taxable income for 2020 was $50,000. Using the long-term capital gains tax brackets above, you see that you’ll only pay 15% on that gain.
Since your ordinary income tax bracket is 22%, by taking advantage of the lower capital gains tax rates, you saved $70 in taxes ($150 versus $220 on a $1,000 capital gain).
On the other hand, if you had a long-term gain on stocks A and B and a short-term gain on stocks C and D, the long-term rate would apply to the long-term gain, and your ordinary tax rate would apply to the short-term gain.
The financial takeaway
Tax planning should never be the sole factor driving an investment strategy. But it can be a factor. If possible, holding onto your investments for more than a year before you even think of selling them can be a big advantage when it comes to paying taxes on your capital gains.
If you need to cash in some investments — for an IRA distribution or just because you need income — capital gains’ special tax treatment can also help you determine which particular holdings to sell, and when. Obviously, you’d sell those that qualify as a long-term gain, for the lower tax rate.
But whether you sell your assets after a few months or a few years, be sure to keep good records of what you bought and sold, when the transaction took place, and how much you paid or received for it. That way, you’ll have all of the information you need to calculate and report your capital gains and losses properly on your tax return.
