Reducing taxes can be a ton of work.
While loopholes do exist, they usually take too much time and effort.
Capital gains are one of the huge exceptions.
Knowing just a few key facts about capital gains could cut your tax rate in half on the money you make from selling an asset.
These rules are simple to remember, easy to implement, applicable to most people, and have a huge impact on your taxes. That’s everything you could possibly want from a tax reduction strategy.
But what are capital gains anyway?
Capital gains are the profits from selling capital assets, such as stocks or other personal property. In some cases, they’re taxed at a lower rate than ordinary income, but not all capital gains are treated equally.
What is the Capital Gains Tax and How It Works
The IRS considers almost everything you own, except for property used in a business, to be a capital asset. Every asset has a “basis,” which is essentially what you paid for it, plus any money you put into improving it.
When you sell a capital asset, the difference between the proceeds of the sale and the basis is either a capital gain or a capital loss. If the sales price is higher than your basis, it’s a capital gain. If the sales price is lower than your basis, it’s a capital loss.
A Complete List of Everything That Qualifies for Capital Gains
You might think of stocks, bonds, and other investments when you’re talking about capital gains taxes. But nearly everything you own, either for personal or investment purposes, is considered a capital asset. Here’s a list of the types of property that may qualify for capital gains:
- Your home
- Personal use items, such as household furnishings
- Stocks, bonds, and other investments
- Collectibles such as coins, stamp collections, antiques, and artwork
2019-2020 Capital Gains Tax Rates
When you sell a capital asset, the gain or loss is classified as either short-term or long-term, depending on how long you owned it before selling it. In most cases, if you owned the asset for more than one year, it’s a long-term capital gain or loss. If you held it for one year or less, the gain or loss is short-term.
Long-term capital gains tax rates
Generally, long-term capital gains are taxed at a lower rate than ordinary income. The rate depends on your filing status and your total taxable capital gains. Here are the long-term capital gains tax rates for 2019.
These are marginal tax rates. No matter how much you earn, you will pay 0% in taxes for the first $39,375. The 15% tax rate only applies to the gains above $39,375. You don’t have to worry about tipping into the next bracket and then having all your gains taxed at a single rate.
Still, these are much better rates than short-term capital gains.
Short-term capital gains tax rates
Short-term capital gains are taxed at the same rate as your ordinary income. The rate you pay depends on your filing status and total taxable income. Here are the ordinary income tax brackets for 2019.
This means that you have a strong incentive to wait for long-term capital gains to kick in before selling an asset. You could cut your taxes in half just by hitting the one-year mark.
How to Calculate Capital Gains Tax
When calculating your capital gains, the most important thing to keep in mind is that the capital gains tax rate doesn’t apply on an item-by-item basis. It applies to your overall net capital gains.
To illustrate, say you had the following stock transactions in 2019:
- Stock A: Long-term capital loss of $3,000
- Stock B: Long-term capital gain of $6,000
- Stock C: Short-term capital loss of $4,000
- Stock D: Short-term capital loss of $2,000
To calculate your net short-term gain or loss, you first need to net your long-term gains and losses and your short-term gains and losses.
- Long-term: Stock A + Stock B = ($3,000) + 6,000 = $3,000
- Short term: Stock C + Stock D = ($4,000) + 2,000 = ($2,000)
Now, you have a long-term gain of $3,000 and a short-term loss of $2,000. When you combine the two, you get, a net capital gain of $1,000.
Assuming these are your only capital gains in 2019, using the long-term capital gain tax brackets above, you see that you’ll pay 0% on that gain.
On the other hand, if you had a short-term gain AND a long-term gain, the long-term rate would apply to the long-term gain portion and your ordinary tax rate would apply to the short-term gain.
Tips for Paying Less Taxes
With such huge differences in tax rates on different types of capital gains, we can save a lot of money by making sure our gains fall into the right tax bucket. The best part about this is that it’s largely under our control. We can choose when to see assets and realize gains.
Here are a few strategies you should consider:
Hold capital gain property for at least one year
Since long-term capital gains are taxed at a lower rate than short-term capital gains, try to hold off on selling until you’re past the one-year mark. The clock starts ticking on the day after you acquire the asset, up to and including the day you sell it.
This is one one the easiest rules to follow and has an enormous impact. If you only use one tip from this list, make it this one.
Defer income and accelerate deductions
If you’re planning on selling an asset that will generate a sizeable short-term capital gain and can’t wait until it would be a long-term capital gain, try to reduce your overall taxable income.
One way to do that is to defer income until next year. For example, if you’re self-employed, you could delay sending invoices to clients until January to ensure that you won’t receive payment until next year.
You can also reduce your taxable income by accelerating deductions into this year. For example, if you usually contribute $5,000 per year to your favorite charity, you could make two or three years’ worth of donations this year instead.
Harvest capital losses
If you own some investments that aren’t performing well and have poor prospects for future growth, you might want to consider selling them and using the loss to offset your capital gains.
For example, say you have $15,000 in capital gains for the year, but you also have a stock in your portfolio that is down by $5,000. If you sold that loser stock, you could use the $5,000 loss to partially offset your gains. Then you’d only owe taxes on $5,000 of capital gains instead of $10,000.
When you’re looking for losses to harvest, focus on short-term losses. These provide a greater benefit because the loss is first used to offset short-term gains, which are subject to a higher tax rate.
If you decide to sell some investments to generate losses, watch out for the wash-sale rule. This rule disallows the tax-write off if you buy the same or a “substantially identical” security within 30 days before or after the date of sale.
What You Need to Know About Capital Gains Tax
There are a few other rules you might need to know when it comes to calculating capital gains tax.
High-income taxpayers might pay more
High-income taxpayers may also have to pay the Net Investment Income Tax (NIIT), which applies an additional 3.8% tax on all investment income, including capital gains.
NIIT applies if your income is above $200,000 for single or head of household taxpayers, or $250,000 for married couples filing jointly.
Losses from the sale of personal property aren’t deductible
As mentioned previously, nearly everything you own, even your car and personal effects, can be considered capital gain property. But that doesn’t mean selling cars or furniture at a loss will get you a tax write-off.
Losses from the sale of personal-use property, including your home and car, aren’t deductible.
Special rules for selling your home
Losses on the sale of your home aren’t deductible, but gains might be taxable. Fortunately, the IRS allows taxpayers to exclude up to $250,000 ($500,000 if married filing jointly) of gain on the sale of their main home.
To qualify, you must’ve owned and used the home as your primary residence for at least two of the last five years.
Inherited property is always long term
If you inherit capital gain property, you don’t have to worry about holding it for more than a year. No matter how long you actually own it, inherited property is always treated as a long-term gain or loss.
Special rates apply to collectibles
If you sell collectibles (such as coins or art) at a profit, those capital gains are taxed at a maximum rate of 28%.
Limits on capital losses
Don’t go overboard with tax loss harvesting. If your total capital losses are higher than your capital gains, you can only use $3,000 of those losses to offset other types of taxable income. You can carry any unused losses forward and deduct them in subsequent years.
Keep good records
Whether you sell property at a loss or a gain, after a few months or a few years, it’s important to keep good records. Track what you bought and sold, when the transactions took place, and how much you paid or received. That way, you’ll have all of the information you need to report capital gains on your tax return.
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