A capital gain is a profit that you make on an investment. For tax purposes, capital gains are treated differently than other types of income such as your salary. This is a plus for investors because capital gains tax rates are generally lower than the rates on ordinary income. The federal government offers this tax advantage in order to encourage investing. This is a substantial tax break, so it is important for all investors to be familiar with capital gains tax, including small business owners who may be considering selling their businesses.
The Basics of Capital Gains
The capital gains tax definition is very straightforward. A capital gain is a profit an investor realizes from the sale of an asset. The capital gains tax is the tax rate that applies to that profit. However, there is more than one capital gains tax rate. The tax rate you pay depends on several factors, including other income and the type of asset sold. For instance, the sale of collectible coins is subject to a tax rate different than that which applies to the capital gain on the sale of stock. People often think of the capital gains tax only as it applies to stocks and bonds. However, almost any asset you own may result in a capital gain when you sell it. Some examples include your home or another real estate asset, a small business and personal property like jewelry, collectibles, precious metals and even furniture.
Capital gains taxes apply only when an asset is sold. Suppose you purchase stock for $1,000 and a year later it is worth $1,500. The $500 increase in value is called a paper profit, meaning it is not taxable unless you decide to sell the stock. A capital gain only becomes taxable when the gain is "realized," meaning you sell the asset and collect the profit.
When you make an investment, there is no certainty that it will be profitable. Consequently, you may decide to sell an asset at a loss for any number of reasons. However, most capital losses are tax deductible. The Internal Revenue Service will not allow you to claim a capital loss on personal property or the sale of a home.
Long- and Short-Term Gains
A capital gain can be classified as either long term or short term. The difference is important because only long-term capital gains qualify for lower capital gains tax rates. Short-term gains are taxed at the same rates that apply to ordinary income. "Ordinary" refers to income like a salary, taxable pension or interest. A capital gain or loss is short term when you sell an asset one year or less from the time you purchased it. If you own the asset for more than one year, the profit becomes a long-term capital gain. To figure the length of time you owned an asset, count from the day after the date of purchase through the date the asset was sold.
How the Capital Gains Tax Works
Capital gains tax rules normally apply only to profits from the sale of an investment. They do not apply to the income you receive as a result of owning an asset. For instance, the profit you make from operating a business is not considered a capital gain. Neither is interest earned by an asset such as a bond since it is income derived from owning the asset. Dividends are also income. However, some dividends are qualified, which means they can be treated as a capital gain for tax purposes.
In general, dividends received from a domestic U.S. corporation, corporations located in U.S possessions and certain foreign companies that are covered by treaty arrangements may be qualified. Dividends paid by a real estate investment trust, tax-exempt corporation, master limited partnership or a savings or money market account are not qualified. You must have owned the stock for at least 60 days, or for 90 days during the 180-day period starting 90 days before the ex-dividend date of the dividend payment.
Capital Gains Tax Rates
You may wonder if reporting capital gains on your tax return will bump your ordinary income into a higher tax bracket. The answer is no. Capital gains tax is figured separately from ordinary income. However, the reverse is not true. Your adjusted gross income not only determines your maximum tax rate on ordinary income, but it also determines the capital gains tax rate that applies to you.
As of 2018, the maximum capital gains tax rate for most assets was 20 percent. This rate applies only to people who are in the highest tax bracket. By contrast, low-income individuals with a maximum tax rate on ordinary income of 15 percent or less pay no income tax on capital gains. The IRS says that most Americans fall between these two extremes and pay a capital gains tax of 15 percent. Suppose Mary Smith sells stock she has owned for more than one year and makes a profit of $1,500. She has a maximum tax rate of 25 percent on her ordinary income. Her capital gains tax rate is 15 percent, so she will owe $225 in capital gains tax.
Some types of assets have different capital gains tax rates. Gains from the sale of collectibles such as coins or stamps have a maximum capital gains tax rate of 28 percent. This 28 percent top rate also applies to the taxable part of a gain from the sale of section 1202 real estate. Section 1202 allows for some gains from the sale of a small business to be excluded from federal tax. The capital gains tax on real estate is the same in most cases as it is for other assets. However, section 1250 of the IRS Code allows ordinary income tax rates to apply to the sale of certain depreciated real estate. However, unanticipated gains from such sales are subject to a maximum capital gains rate of 25 percent.
Calculation of Capital Gains Taxes
The basic approach to calculating capital gains tax starts with figuring out your basis. The basis is the total amount of money that you have invested to acquire the asset. In most cases, this is the purchase price plus any associated costs. However, you may have received the asset as a gift or inheritance. In this situation, your basis is generally the value of the asset on the day you became the owner, regardless of how much the original owner may have paid to acquire the asset. It is extremely important to calculate the basis correctly since this amount is not taxable.
You also need to compute the net proceeds from the sale of the asset. The net proceeds are equal to the selling price minus any transaction costs. Once you have determined the basis and net proceeds, subtract the basis from the net proceeds to find the capital gain. Be sure to note the dates of acquisition and sale of the asset so you can classify the capital gain as short or long term.
As an example, suppose John Smith buys 100 shares of stock for $50 per share. He holds the shares for two years and then sells them for $75 per share. Since he owned the stock for more than a year, he has a long-term capital gain. If John had sold the shares for less than $50 per share, he would have realized a capital loss. Next, multiply the per-share purchase price by the number of shares. This is $50 times 100, or $5,000. The brokerage fee was $25, so John's basis is equal to $5,025. The sale price equals $75 multiplied by 100 shares, or $7,500. Subtract the broker's fee of $25 to figure the net proceeds of $7,475. Finally, subtract the basis from the net proceeds. In this example, this is $7,475 minus $5,025. The capital gain equals $2,450.
Calculating the capital gain for a single stock transaction is fairly simple. For some assets such as a small business or real estate, it can be more complex. Even a stock sale can be complicated. For instance, if you reinvest dividends while you own the stock, you have to add the amount of the dividends to the basis. The most recent dividend reinvestment may result in a portion of the capital gain or loss being short term, even if the remainder is a long-term gain.
Offsetting Capital Gains with Losses
When you regularly buy and sell securities like stocks and bonds, the odds are that some transactions will result in short-term gains or losses, while others will yield a long-term gain or loss. The good news is that you can use the losses to offset gains, and so reduce your tax liability.
Here's how to offset capital gains with losses. First, divide all of your transactions into four categories: short-term capital gains, short-term capital losses, long-term capital gains and long-term capital losses. For example, suppose you had three short-term capital gains of $500, 1,000 and $1,000. Your total short-term capital gains total adds up to $3,000 for the year. The IRS rules say you must first offset short-term gains with short-term losses and long-term gains with long-term capital losses. If you have a net loss of one type left over, you can then use it to offset a gain of the other type.
For example, if you had $3,000 in short-term capital gains and $4,000 in short-term capital losses, you can use the remaining $1,000 short-term capital loss to offset any long-term capital gain. If you still have losses left over after offsetting capital gains, you can use up to $3,000 of these losses to offset ordinary income. If you had a bad year investing and still have a remaining capital loss, you could carry it forward to use as a tax deduction in a future year.
Reporting Your Capital Gains Income
Capital gains are reported along with your other income using IRS Form 1040. Use IRS Form 8949, "Sale and Other Distribution of Capital Assets," to report the details of your capital gains transactions. You must also complete IRS Form 1040, Schedule D, "Capital Gains and Losses." Schedule D summarizes your gains and losses. Attach both Form 8949 and Schedule D to your tax return.
Many people invest in mutual funds. If you are one of these, you may realize a capital gain even if you do not sell any of your mutual fund shares. Here's why. Your mutual fund dollars are used to buy stocks and other securities. During the year, the fund manager may decide to sell some assets at a profit, which results in a taxable event. However, it is the fund shareholder who is liable for any capital gains taxes, not the fund. To make things easier, the fund provider must calculate your share of any taxable capital gain and send the information to you.