Capital gains tax is imposed on gains realized from the sale of capital assets such as a home, an investment, or a business interest. Special maximum tax rates generally apply to long-term capital gains; these rates are typically lower than the rates that apply to ordinary income.
When Do I Pay Capital Gains Tax?
If you sell or exchange a capital asset for more than its cost, the profit is a capital gain. If you sell or exchange a capital asset at a loss, you can generally use the loss to offset capital gains.If your capital losses exceed your gains, you can offset a certain amount of ordinary income and/or carry the loss forward into future tax years.
The tax rate that will apply to the sale or exchange of a capital asset depends on a number of factors, including the type of asset, how long you owned (held) the asset, and your taxable income.
Tip: Under the homesale exclusion, gain on the sale of your principal residence (up to certain limits) can be excluded from income, as long as certain conditions are met.
Caution: Generally, loss resulting from the sale or exchange of personal property is not deductible. A loss on the sale or exchange of property between related parties is also generally not deductible.
What is a capital asset?
Just about everything you own and use for personal purposes or for investment purposes is a capital asset. However, capital assets do not include:
- Inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of your trade or business
- Depreciable or real property used in your trade or business
- Certain literary or artistic property
- Business accounts or notes receivable
- Certain U.S. publications
- Certain commodity derivative financial instruments
- Hedging transactions
- Business supplies
Caution: When you sell or dispose of business property, special rules apply under IRC Section 1231. When you sell or dispose of depreciable property, special rules under IRC Sections 1245 and 1250 may also apply. For more information, see IRS Publication 544, Sales and Other Dispositions of Assets.
Holding period refers to the length of time you held a capital asset before selling or exchanging it. A gain is classified as short-term if you held the asset for a year or less before selling it, and long-term if the asset was held for longer than a year. This distinction is important because net short-term capital gains are taxed at ordinary income rates, whereas long-term capital gains are taxed at the more favorable long-term capital gains tax rates.
How Do Capital Gains Tax Rates Differ From Ordinary Income Tax Rates?
Capital gain income is generally preferable to ordinary income. Currently, the highest marginal income tax rate is 37 percent, while long-term capital gains tax rates vary from 0 percent to 28 percent, depending on the asset and your taxable income. Generally, current long-term capital gains tax rates can be grouped as follows:
- 28 percent for collectibles and small business stock
- 25 percent for unrecaptured IRC Section 1250 gain
- 0 percent, 15 percent, and 20 percent for most long-term capital gains and qualified dividends, depending on your taxable income.
The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income.
Frequently Asked Questions
If your capital gain in a given year pushes you into a higher capital gain tax bracket, which capital gain rate do you use?
Suppose you are normally in the 0 percent capital gain tax bracket, but in December of this year, you sell an asset held for two years and realize a substantial long-term capital gain. Will the full capital gain be untaxed because of the 0 percent rate? Maybe not. If your capital gain pushes you into a higher capital gains tax bracket, you can use a preferred capital gains tax rate of 0 percent on a portion of the capital gain only. The remainder of your capital gain will be taxed at the higher 15 percent rate.
Example(s): Assume John has taxable income that is $10,000 less than his capital gains rate threshold for 15 percent. He realizes a long-term capital gain of $40,000 and his taxable income increases to $30,000 greater than his capital gains rate threshold for 15 percent. $10,000 of his net capital gain is taxed at 0 percent and $30,000 is taxed at 15 percent.
What are the netting rules?
Capital gains and losses may offset one another based on a set of principles known as the "netting rules." Generally speaking, the tax code prescribes that short-term capital gains and losses must be netted against each other first. Next, long-term capital gains and losses are netted against one another according to a set of ordering rules. Finally, net short-term gains or losses must be netted against net long-term gains or losses in a prescribed manner.
Capital losses are netted against capital gains. Up to $3,000 in excess capital losses is deductible against ordinary income each year. Unused net capital losses are carried forward indefinitely and may offset capital gains, plus up to $3,000 of ordinary income during each subsequent year. (The $3,000 limit is reduced to $1,500 for married persons filing separately.)
Example(s): Assume Jane has a short-term capital gain of $1,200 and a short-term capital loss of $1,300, resulting in a net short-term capital loss of $100. She also has a net long-term capital gain of $600 and a net long-term capital loss of $4,200, resulting in a net long-term capital loss of $3,600. The excess of Jane's capital losses over capital gains is $3,700 ($100 + $3,600). This excess is deductible from ordinary income up to a maximum of $3,000 this year; the remainder may be carried over to future years.
When you carry over a loss, it retains its original character as either long-term or short-term (e.g., a short-term loss you carry over to the next tax year is added to short-term losses occurring in that year, and a long-term loss you carry over is added to long-term losses occurring in that year). A long-term capital loss you carry over to the next year reduces that year's long-term gains before its short-term gains. If you have both short-term and long-term losses, short-term losses get used first in calculating your allowable loss deduction.
How Can I Reduce My Tax Burden?
Time your capital gain recognition
Careful planning may save you taxes. For example, because capital gain or loss is not recognized for federal income tax purposes until you dispose of an asset, in many cases you have some control over the timing of recognition. If you believe that you will be in a lower tax bracket next year, you can choose to postpone the sale of a capital asset to defer recognition of gain or loss until that year.
Plan your year-end capital gain and loss status
If you realize a capital gain this year, you should consider reviewing your portfolio for potential losses, and decide whether it makes sense to recognize losses to offset your gain. Remember also that you can use up to $3,000 ($1,500 if married filing separately) worth of losses (if applicable) to offset ordinary income.
Similarly, if you have a capital loss this year (or have a capital loss carryforward), you should review your portfolio for potential gains for offset purposes. This may help to lower your overall tax liability.
For property held as an investment, elect to include gain in investment income
You may elect to treat capital gains from investment property as investment income instead. If such an election is made, gains will be taxed at ordinary rates and can be used to offset investment interest expenses. This may be advantageous for individuals who have sufficient capital losses to offset capital gains, and insufficient investment income to offset investment interest expenses.
What are qualified dividends?
Qualified dividend income generally includes dividends received from domestic corporations and qualified foreign corporations. If holding period requirements are met, qualified dividends are taxed at the same rates that apply to net capital gain.For purposes of calculating federal income tax, qualified dividends are taxed at the same maximum rates that generally apply to long-term capital gains. For this purpose only, they are added to net capital gain and adjusted net capital gain in the capital gain tax calculation. However, qualified dividends are not netted against capital gains and losses, and capital losses cannot be used to offset qualified dividend income.
Adding a wealth management advisor to your planning team can help you determine the most tax efficient way to manage your investments while still meeting your financial goals.