One of the great ways to build wealth is to put your money to work for you through investments, such as stocks or real estate. As long as you continue to own your investments, you don’t have to pay taxes on the paper gains and you don’t get to write off paper losses. But, once you sell the investments and realize the gains or losses, you have to report them on your taxes. Knowing how capital gains are taxed helps you budget for how much of your profits you can spend or reinvest after ensuring your obligations to the IRS are satisfied.
Calculating Capital Gains
When you sell a capital asset, you don’t have to pay taxes on the entire sales price. Instead, you only pay taxes on the profits from the sale. To calculate your taxable gains, you need to know your basis and your sales proceeds.
Your basis is usually what you paid to acquire the assets, including any transaction fees. For example, if you buy $1,340 of stock and pay a $10 trading fee, your basis for the stock is $1,350. If you receive the property as a gift, you use the same basis as the person who gifted it to you. If you inherit the property from a decedent, your basis is the fair market value of the property as of the decedent’s date of death, regardless of what the decedent paid for it.
This can generate substantial income tax savings. For example, say your parent bought the stock for $3,000 decades ago and now it’s $23,000. When you inherit it, your basis becomes $23,000 and that $20,000 of gains escapes income taxes forever.
Your net proceeds represent what you pocket from the sale of the capital asset after accounting for transaction costs. For example, if you sell stock for $1,560, but paid a $10 transaction fee, your net proceeds are $1,550. Once you know your net proceeds, subtract your basis to find your net capital gain. For example, if your basis is $1,350, subtract $1,350 from $1,550 to find your capital gain is $200.
Types of Capital Gains
Capital gains are broken down into long-term capital gains and short-term capital gains. Short-term capital gains refer to profits from selling assets that you’ve owned for one year or less. Long-term capital gains refer to profits from selling assets you’ve owned for more than one year.
There are two notable exceptions to figuring your holding period for certain assets. First, if you were gifted an asset, you get to tack the donor’s holding period on to yours. For example, if your mom held stock for 10 years before gifting it to you, and you sell it six months after it was given to you, your gains would still be counted as a long-term capital gain because the combined holding period is longer than one year. Second, when you inherit assets from a decedent that were included in the decedent’s estate, the gains are always treated as long-term gains.
Capital Gains Tax Rate
The distinction between short-term capital gains and long-term capital gains becomes very important with regard to tax rates. Short-term capital gains don’t receive any preferential income tax treatment and are taxed just like ordinary income. Long-term capital gains, on the other hand, receive preferential tax treatment and are taxed at much lower rates.
In 2020, the ordinary income tax brackets range from 10 percent to as high as 37 percent. For married couples filing jointly, the top 37 percent tax bracket doesn’t kick in until income is $622,051 or greater. The top rate also kicks in at $518,401 for heads of household and singles, and $311,025 for married couples filing separately.
For 2020, long-term capital gains are taxed from a minimum of 0 percent to a maximum of 20 percent as follows:
- For married couples filing jointly, capital gains that would put your total income below $80,000 are taxed at 0 percent, capital gains that boost your income between $88,001 and $496,600 are taxed at 15 percent, and capital gains that put your income over $496,600 are taxed at 20 percent.
- For married couples filing separately, the 0 percent rate applies when the income is up to $40,000, 15 percent between $40,001 and $248,300 and 20 percent when it’s over $248,300.
- For heads of household, the 0 percent rate applies when the income is up to $53,600, 15 percent between $53,601 and $469,050 and 20 percent when it’s over $469,050.
- For singles, the 0 percent rate applies when the income is up to $40,000, 15 percent between $40,001 and $441,450 and 20 percent when it’s over $441,050.
Net Investment Income Tax
If your total income is high enough, both long-term capital gains and short-term capital gains are subject to a 3.8 percent net investment income tax. The net investment income tax applies to the smaller of your net investment income or the amount by which your adjusted gross income, including your net investment income, exceeds the tax threshold.
As of 2020, the thresholds for the net investment income tax are $250,000 if you’re married filing jointly or a widow or widower with a qualifying child, $200,000 if you’re single or head of household and $125,000 if you’re married filing separately.
For example, say you’re single and you have $20,000 of net investment income. If you have a salary of $194,000, you would pay the net investment tax on $14,000 of your income because your total income exceeds the $200,000 threshold by just $14,000 – less than your net investment income. But, if your salary was $205,000, you would pay the net investment income tax on the full $20,000 if investment income.
How to Calculate Net Capital Gain
Unless you’re the first investor to never have a loss on an investment in history, you’ll have at least a few losses mixed in with your gains. You can use the losses to offset your capital gains to figure your net capital gain for the year. However, you must follow the tax code’s rules for determine which losses offset which gains.
First, you must use your long-term capital losses to offset your long-term capital gains and your short-term capital losses to offset your short-term capital gains. Only after you have offset all of your capital gains of one category can you use the excess to offset capital gains of another category.
Example of Calculating Net Capital Gain
Say that in a given year, you have $4,000 of long-term capital gains, $7,000 of long-term capital losses, $3,000 of short-term capital gains and $2,000 of short-term capital losses. Use $4,000 of your $7,000 total long-term capital losses to offset all of your long-term capital gains. Second, use all of the short-term capital losses to offset $2,000 of the short-term capital gains, leaving you will $1,000 of short-term capital gains left. But, because you have $3,000 of excess long-term capital losses after offsetting all of your long-term capital gains, you can use $1,000 of those losses to wipe out your short-term capital gains.
If you have capital losses in excess of your capital gains, you can use those losses – up to a $3,000 annual limit – to offset your ordinary income. But, if you file as married filing separately, you are limited to having each spouse use no more than $1,500 of losses each year to offset other income.
Any excess capital losses over the limit can be carried forward to future years, with no expiration date. For example, if you’re single and have $5,000 excess capital losses, you can reduce your other taxable income by $3,000 and carry the excess $2,000 capital loss to the following year.
Exceptions to Capital Gains Rates
Though the capital gains tax rates apply to most transactions, there are a few types of transactions that are taxed differently. For example, when you sell collectibles, a 28 percent tax rate applies instead of the lower long-term capital gains rates. However, if a lower ordinary income tax applies, you pay tax at that rate rather than the 28 percent collectibles rate. Collectibles include items like paintings, sculptures, antiques, precious metals or gems, stamps, coins or alcoholic beverages like wine.
Making Estimated Tax Payments
If you’re making money on your investment income, you may need to make estimated tax payments throughout the year to avoid having to pay penalties for underpaying your income taxes throughout the year. When the vast majority or all of your taxable income comes from your wages working as an employee, your estimated tax payments are generally covered by the income taxes withheld from your paychecks by your employer. But, your capital gains are subject to income tax withholding.
You can meet your minimum tax payment responsibilities through one of the safe harbors offered by the IRS.
Safe Harbor: Estimated Payments of 90 Percent
The first option is to make sure that your withholding plus quarterly estimated tax payments are at least 90 percent of what you owe for the year. For example, if you end up owing $9,000 in total income taxes on your federal return, your withholding plus estimated tax payments must equal at least $8,100 to avoid underwithholding penalties.
It can be hard to accurately guess what you’re going to owe in taxes, especially when a chunk of your income is coming from capital gains. The value of your assets could shoot up dramatically higher than you ever dreams, but they could also come crashing down, leaving you stuck without a good guess as to how much you’ll actually owe in taxes. As a result, you may want to rely on a second safe harbor for income tax withholding which is based on your tax liability from the prior year.
Second Safe Harbor: Estimated Payments Equal to or More than the Prior Year
To qualify for the second safe harbor, most taxpayers need to have their tax withholding plus estimated payments equal or exceed their tax liability for the prior year. For example, if last year your total tax liability was $11,500 you’ll avoid any tax penalties if you have at least that much in withholding and estimated tax payments this year.
If your adjusted gross income from the prior year exceeds $150,000 (or $75,000 if you’re married filing separately), you’re considered a higher-income taxpayer. As a result, the second safe harbor is a little higher for you than everyone else. Instead of having a 100 percent threshold, your threshold is 110 percent.
For example, if as a higher income taxpayer you have a tax liability of $14,000 last year, you need $15,400 in withholding and estimated tax payments this year. If you owe more than that, you’ll still need to pay the difference, but you won’t have to pay any penalties. And, if you don’t owe as much as you’ve had withheld, you’ll receive the excess back as a refund when you file your taxes.
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- Capital-loss deductions are limited to $3,000 for married couples and $1,500 for individuals. Any excess can be carried over to the next tax year.
- If you had capital gains from selling collectibles, the maximum tax rate would increase to 28%.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."