You generally pay capital gains tax when you sell an asset that's gone up in value, whether it's real estate or securities like stocks and bonds. If you don't sell the asset, you can usually hold on to it as long as you wish without owing capital gains tax. There are special rules for tax on the sale of property such as land, condominiums and other real estate.
You generally don't owe any kind of capital gains tax until you sell or otherwise dispose of an asset on which the tax is due. You can hold on to assets for as long as you want without selling them and avoid having to pay capital gains tax.
Capital Gain Definition
Capital gain refers to the increase in value on an asset, whether it's real estate, stocks or bonds.
You can generally hold on to an appreciating asset as long as you wish without paying any tax, but when you sell the asset, you will have to pay capital gains tax. Long-term capital gains tax is assessed on the sale of assets you've held for a year or longer, generally at a lower rate than you'd pay on ordinary income. Most taxpayers pay 15 percent capital gains tax, though people with high income pay 20 percent and people with low income may not owe tax at all on long-term gains.
If you hold on to the property for less time, you'll owe short-term capital gains tax when you sell it, which you'll pay at your usual ordinary income rate, the same as you'd pay on income from work, bank interest or stock dividends.
Your capital gain on an asset sale is based on the sale price, save any sales commission, minus the purchase price, to which you add any purchase commission. That latter total is known as the cost basis of the asset.
Deducting Capital Losses
Not all assets go up in value. You might occasionally sell a stock or a piece of real estate that's declined in value over the time you've owned it.
That's known as a capital loss. You can deduct capital losses from your capital gains in the same year, reducing the amount you'll owe in capital gains tax. Or you can deduct $3,000 in capital losses from your ordinary income, whichever amount is lesser.
If you have more capital losses in a particular tax year than you can offset against your gains or your other income, you can roll them into future years. Continue rolling capital losses forward until you effectively use them up as deductions against capital gains and ordinary income.
The Basis on Inherited Assets
Special rules apply if you inherit assets, sell them later, and achieve capital gains.
Inherited assets generally acquire their cost basis on the date the previous owner passed away, rather than on the date he or she purchased them. In some cases, estate administrators or executors can choose an alternate date six months after the original owner died to set the basis. Use published stock prices or an appraisal to set the cost of inherited capital assets.
Assuming asset prices have risen since the original owner bought them, this can save a considerable amount of tax for someone who inherits real estate, stocks and bonds or other capital assets. This also affects many people's estate planning decisions as they age and decide whether to sell particular assets or leave them to their heirs.
Giving Away Capital Assets
Special rules also apply if you give charitable assets to an Internal Revenue Service-recognized charity, such as a 501(c)(3) organization or a local house of worship.
Generally, you can deduct the fair market value of goods you donate to charity from your federal taxable income. If you donate cash, you can deduct the amount you donate.
If you donate capital goods, you can deduct their fair market value and don't have to pay capital gains tax on them. This can be beneficial compared to selling some of your property and donating the dollars you receive, which would earn you the same income tax deduction but would also require you to pay capital gains tax on the sale of the property in question.
Special rules apply if you donate a car that is soon sold by a charity, in which case you may have to deduct based on the actual sale price rather than the presumed fair market value. If your donated assets exceed $5,000 in value, you may need to get an appraisal of the property and include it with your income tax filing.
Capital Gains on Real Estate
One of the most common ways to incur capital gains tax is by selling real estate.
The IRS does allow you to avoid paying tax on some of the capital gains from many common real estate sales, assuming the property in question is your main residence. If you're single, you can exclude up to $250,000 in capital gains on your primary residence when you sell it for a gain. If you're married and filing federal income tax jointly, you can exclude up to $500,000 from your taxable income when you sell your primary residence at a gain.
To claim such an exemption, certain conditions must apply. The property must be your primary residence and you must have lived in it for at least two total years in the five-year period before you sell it. There are some exemptions for people in the military and disabled people.
You also can only claim this exclusion once every two years.
The Wash Sale Rule
Ordinarily, if you're selling stock or other securities, you can claim a capital loss on any depreciation in value and must pay capital gains tax on any appreciation. However, a special rule applies if you sell securities and buy the same securities, or ones that are essentially identical, within a 30-day period before or after the sale. This is known as the wash sale rule.
In this case, you can't deduct any capital loss on the securities you have sold. Instead, you add any loss to the cost basis of the newly purchased securities, which will enable you to take a capital loss or reduce your capital gain when you finally sell them for good. This is to prevent people from selling securities when they've depreciated in value, then buying the same securities shortly before or after and claiming a capital loss.
Retirement Accounts and Appreciation
If you have a retirement account such as a 401(k) set up by your employer or a traditional individual retirement arrangement you've opened for yourself, special rules apply.
You generally don't pay tax on money you put into such an account or on sales of assets within the account that don't end up with cash withdrawals. Instead, you deduct your contributions from your income tax and pay tax on funds you take out of the account. This lets you defer your tax obligations until retirement age, when many people find themselves in a lower income-based tax bracket than while they were working.
You pay an additional tax penalty if you withdraw from an IRA or 401(k) before retirement age. After age 70 1/2, you must begin withdrawing from such accounts or face harsh tax penalties.
Understanding Roth IRAs
Roth IRAs work differently from traditional IRAs and ordinary investment accounts.
The funds you contribute to a Roth IRA are taxed as usual when you earn them, but you don't pay tax on withdrawals from the account once you reach retirement age, including withdrawals of investment earnings.
In many cases, you can save on taxes by keeping investments within a Roth IRA rather than a traditional IRA, a 401(k) or a brokerage account subject to capital gains tax.
- IRS: Topic No. 409 Capital Gains and Losses
- IRS: Is Money Received From the Sale of Inherited Property Considered Taxable Income?
- IRS: Publication 526, Charitable Contributions
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Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.