With a few exceptions involving real estate, the Internal Revenue Service treats all gains on the sale of capital assets the same way. Assets held for more than a year qualify for favorable long-term capital gains treatment. Low-income taxpayers may not have to pay any tax on these gains at all, and even high-income taxpayers pay no more than 20 percent, about half the rate for ordinary income in the top tax brackets. Classifying profits as capital gains rather than ordinary income can save you money, and you can often avoid or reduce capital gains taxes with one or more strategies.
Avoiding Capital Gains Tax
Short-term capital gains, which are gains on assets held for less than one year, are taxed like ordinary income. Long-term capital gains are taxed at a reduced rate.
An easy way to qualify the sale of an asset as a long-term capital gain is to retain ownership of it for more than a year. Sales of individual stocks and bonds are straightforward, but you can take a capital gain on the sale of almost anything you own, provided it's not business property like inventory and merchandise. Almost anything else of value you use to make money can qualify. Mutual fund sales are a little more complicated because even while you hold the fund, its assets are probably being sold by the fund's managers. It pays to find out how active your fund managers are for this reason. Those who turn assets quickly cost their clients money by shifting assets from capital gains treatment to ordinary income treatment at tax time.
Capital Gains Exemptions for Sale of Your Home
Capital gains on a home sale have a unique benefit if the home is your primary residence. If your home sale qualifies, you can avoid capital gains tax up to a certain amount. Determine if your sale qualifies according to these criteria:
- During the most recent five-year period, you owned the home for at least two years.
- During the same five-year period, you lived in the home as your primary residence for at least two years.
If your residence qualifies, this opens a legal tax-avoidance window. If you file your taxes jointly with your spouse and you're willing to go through the inconvenience, $500,000 in profits on the sale of a rental property can become tax-free if you move in and use the property as your primary residence for two years prior to its sale. If you're a single filer, you can exclude up to $250,000 in profits this way. If your gain is below the exemption threshold, you don't even need to report the sale on your tax return. This is true for the 2017 and 2018 tax years, as the new tax law did not change these amounts.
Defer Capital Gains Tax
Capital gains tax on the sale of property is normally due at the time of sale. By exchanging the property for another instead of selling it, however, you can defer the capital gains tax. A 1031 exchange can be used to defer gains on real estate, as well as any other asset, if you use the proceeds to buy something of like kind, such as the same type of asset, although not necessarily of the same quality.
The simplest swap is an even-up exchange of one property for another with no money changing hands, but that's not always practical or possible. Instead, you can arrange an exchange where, according to the IRS, "the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction."
If this sounds complicated, it is. Most investors hire a 1031 specialist to manage the exchange. This is often a tax lawyer who specializes in them. You can defer capital gains taxes almost indefinitely by engaging in a series of such exchanges.
- IRS: Topic Number: 409 - Capital Gains and Losses
- Charles Schwab: New Tax Law: Here’s What You Should Know
- NOLO: Capital Gains Versus Ordinary Income
- U.S. News & World Report: How Mutual Fund Trading Costs Hurt Your Bottom Line
- IRS: Sale of Residence - Real Estate Tax Tips
- IRS: Like-Kind Exchanges - Real Estate Tax Tips
- Forbes: Ten Things to Know About 1031 Exchanges
- Asset Preservation Inc.: Impact of the 2018 Tax Law on Real Estate Owners