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, or 366 days or more before you sell them, 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. Due to the new tax bill likely affecting capital gains taxes, this information is valid through the 2017 tax year.
Timing the Sale
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. There's no evidence that funds with high turnovers outperform funds with low turnovers. In fact, there's some evidence they perform worse, even before factoring in higher taxes.
Capital Gains Exemptions
The gain on the sale of your primary residence receives a unique capital gains tax benefit. You can 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.
Capital Gains Reductions
You could employ the same strategy to avoid capital gains on the sale of a second home until 2009, but that's no longer the case. You still may be able to reduce your capital gains from the sale of a second home, however. Calculate the capital gains tax by dividing the number of years you used the property as a primary residence by the total number of years you owned the home. For example, if you owned the second home for five years, used it as your primary residence for three years and have a capital gain of $200,000, you can exclude three-fifths of that gain, or $120,000, from taxation. It's usually a good idea to discuss this strategy first with your tax advisor, however.
Capital Gains Deferrals
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.
Related Tax Strategies
• You can match gains and losses. If the timing works, delay the sale of an asset so it falls in the same tax year as a deductible capital loss.
• You're only allowed to deduct $3,000 in stock market losses each year unless you're a professional trader. If you have losses that exceed this amount, you can take $3,000 in one tax year and defer the balance to the following tax year. If an asset has already lost most of its value, it may be worth selling it over several years, taking a $3,000 loss each year until the equity is completely gone. That way, you get the full tax value of the loss.
- IRS: Topic Number: 409 - Capital Gains and Losses
- Schwab: Taxes - What's New for 2017?
- NOLO: Capital Gains Versus Ordinary Income
- U.S. News & World Report: How Mutual Fund Trading Costs Hurt Your Bottom Line
- ETF: Europe ETF Overview
- IRS: Sale of Residence - Real Estate Tax Tips
- Bankrate: Second-Home Tax Rules to Change
- IRS: Like-Kind Exchanges Under IRC Code Section 1031
- Forbes: Ten Things to Know About 1031 Exchanges