Individuals who acquire and sell personal and investment assets must deal with the capital gains tax system in addition to sales tax, excise tax, property tax, income tax, and payroll tax.
A portion of the profit from the sale of a capital item, such as a car or stock or bond or piece of jewelry or real estate, will almost certainly be subject to capital gains tax.
Rates of capital gains can range from zero to 37 percent. As a result, it’s worthwhile to look into ways to minimize these taxes.
The Fundamentals of Capital Gains Taxation
An asset’s sale price is considered a capital gain if it is more than the asset’s cost basis. It is possible that the purchase price constitutes the asset’s “basis.” But if you have improved the asset, you have to pay for those enhancements, which boosts your base. The asset’s basis is diminished if you depreciate it.
Rates of Capital Gains Tax
Capital gains are taxed under two separate schemes:
- Short Term Capital Gains. Assets held for less than a year qualify for Short-Term Capital Gains, which are taxed as ordinary income. Ordinary income tax rates apply to short-term capital gains. Payroll taxes are the same regardless of whether the money is earned from a job, a side gig, or interest earned. Based on your total taxable income, the tax rate you must pay ranges from 10% to 37% for the year 2021.
- Long Term Capital Gains. Gains on investments held for more than a year are known as long-term capital gains. Tax rates on long-term capital gains are lower. Taxes on long-term capital gains might range from 0% to 20%, depending on your individual income. Collectibles sales are taxed at a rate of 28 percent.
Exemption for the Sale of a Primary Residence
When you sell your principal house, capital gains are subject to special regulations. If you fulfill the ownership and usage standards, you can exclude up to $250,000 if you are single, or $500,000 if married and filing jointly. The requirements are satisfied if you own and use your home as your principal residence for two of the five years before the date of sale.
You can satisfy the ownership and usage criteria across two-year intervals, but both must be satisfied within the five years before the date of sale. This capital gains deduction is also known as a Section 121 exclusion.
Capital Gains Reporting and Payment
In addition to regular income, capital gains are included in your yearly tax return. Schedule D is used to record transactions involving capital gains. Form 8949 is used to track the sale of securities. Form 1040, line 7, reports all capital gains and losses (up to $3,000) for the year.
You may quickly enter your capital gain numbers for the computation of your tax due if you utilize tax preparation software such as H&R Block.
Capital gains are not subject to federal or state taxation in the same way that wages are. The IRS may require quarterly anticipated tax payments from you if your capital gains are substantial.
Make sure you don’t owe any estimated taxes by completing the worksheet on Form 1040-ES. The next tax year’s estimated tax payments are due on April 15, June 15, September 15, and January 15. The due date is moved to the following business day if that date falls on a weekend or holiday.
Strategies for Reducing Capital Gains in General
Whatever personal or financial assets you want to sell, there are several measures you may employ to reduce the capital gains tax for which you are due.
- Wait more than a year before selling
When an asset is kept for more than a year, capital gains qualify for long-term status. If the gain is long-term, you are eligible for the reduced capital gains tax rate.
In addition to the aforementioned rates, high-income persons may be subject to the Net Investment Income Tax (NIIT) on capital gains. All investment income, including capital gains, is subject to an extra 3.8 percent tax under NIIT. If your income exceeds $200,000 for single and head of household taxpayers, or $250,000 for married couples filing a joint return, you must pay NIIT.
As you can see, the distinction between a long-term and a short-term transaction might be substantial. Assume you’re a single individual with a total taxable income of $39,000. If you sell shares and make a $5,000 capital gain, the difference in tax depends on whether the gain is short-term or long-term:
- Short-Term (Held a Year or Less Before Sold), Taxed at 12%: $5,000 x 0.12 = $600
- Long-Term (Held Longer Than One Year Before Sold), Taxed at 0%: $5,000 x 0.00 = $0.
When the stock is long-term, it will save you $600. Be patient because the gap between short- and long-term might be as little as one day.
- Capital Gains With Capital Losses
Capital losses cancel out capital gains in a given year. For example, if you gained a $50 capital gain selling Stock A but lost $40 selling Stock B, your net capital gain is the difference – a $10 gain.
Assume you made a loss on a stock sale. If you own additional stocks that have grown in value, consider selling some of them, reporting the gain, and using the loss to offset the gain, lowering or eliminating your tax on the gain. However, both transactions must take place during the same tax year.
This approach may sound familiar. It’s also known as tax-loss harvesting. Many robo-advisors, including Betterment and Wealthfront, provide this service.
Use your capital losses to decrease your capital gains tax in years when you have capital gains. All capital gains must be recorded, but you may only deduct $3,000 in net capital losses every tax year. You can carry capital losses of more than $3,000 forward to future tax years, but it may take some time to use them up if a transaction resulted in a particularly significant loss.
- When Your Income Is Low, Sell
If you experience short-term losses, the rate you pay on capital gains is determined by your marginal tax rate. As a result, selling capital gain assets during “lean” years may reduce your capital gains rate and save you money.
If your income is set to fall, such as if you or your spouse quit or lose a job, or if you’re preparing to retire, sell during a low-income year to reduce your capital gains tax rate.
- Lower Your Taxable Income
Because your short-term capital gains rate is determined by your income, general tax-saving methods can assist you in qualifying for a lower capital gains rate. It’s a good idea to maximize your deductions and credits before filing your tax return. Donate money or products to charity, for example, and complete costly medical treatments before the end of the year.
Contribute the maximum possible amount to a conventional IRA or 401(k) to get the biggest tax break. Keep a look out for unusual or little-known tax breaks that might help you save money. Consider municipal bonds rather than corporate bonds when investing in bonds.
Municipal bond interest is free from federal taxation and so not taxable income. There are several possible tax benefits. Using the IRS’s Credits & Deductions database may alert you to deductions and credits you’ve previously overlooked.
- Do a 1031 Exchange
Section 1031 of the Internal Revenue Code is referred to as a 1031 exchange. It permits you to sell an investment property and defer paying taxes on the gain for 180 days if you reinvest the earnings in another “like-kind” property.
The concept of like-kind property is rather wide. If you own an apartment complex, you may trade it in for a single-family rental property or even a strip mall. It cannot be exchanged for shares, a patent, company equipment, or a residence in which you intend to live.
The essence to 1031 exchanges is that you postpone paying tax on the appreciation of the property, but you do not get to dodge it totally. You’ll have to pay taxes on the gain you avoided by conducting a 1031 exchange when you sell the new property later.
The rules for carrying out a 1031 exchange are complex. If you’re considering one, consult with your accountant or CPA, or engage with a business that specializes in 1031 exchanges. This is not a do-it-yourself method.
Savings on Capital Gains When Selling Your Home
- Limit Your Home’s Rental Use
Assume you are unable to sell your property within the time frame you wish, so you opt to rent it. Renting it may result in a paper loss that you might use to lower your taxable income. Such a loss is normally the consequence of the property’s allowable depreciation. Two factors, though, may dampen your enthusiasm.
First, because you are renting your property, it is no longer your principal residence, thus you are reducing your ownership and using criteria that would allow you to exclude capital gains when you sell. If you have lived in your home for five years, consider renting for only two to three years in order to fulfill the standards for capital gains exclusion when you sell.
Remember that in order to qualify for the exclusion, you must have lived in the property as your principal residence for two years in the five years before the date of sale.
Second, because you rented the property, you must recoup the depreciation. That reclaimed depreciation can be taxed in several ways. For a (lengthy) explanation of whether recaptured depreciation resulted in capital or ordinary gain, see IRS Publication 544, “Sales and Other Disposition of Assets.”
In the end, you could save more money by not renting your house at all. You avoid more complicated tax preparation, you prevent a drop in your base owing to depreciation, and you avoid the complication of recaptured depreciation. When everything is said and done, you may have lost money on the renting experience due to the recovered depreciation.
- Maintain Home Improvement Records
Over time, the changes and additions you make to your house contribute to your ownership stake. When you sell your home, a lower capital gain is associated with a greater basis. If your gain exceeds the exclusion amount for which you qualify or if you do not fulfill the ownership and use requirements, you will save money on your taxes.
Any improvement that enhances the value of your house, extends its useful life, or adapts it to new uses is considered an improvement that raises the basis, according to the IRS.
Adding a room, a deck, a swimming pool, a retaining wall, or landscaping the property are all examples of modifications you may do. Adding new windows and doors, plumbing, insulation, heating, cooling, or sprinkler systems, as well as renovating, adding new flooring, and installing built-in appliances, are all examples of home improvement projects that qualify.
You should keep a record of all the purchases you’ve made and preserve a copy of all receipts and documents.
- Track Selling Expenses
When selling a house, any expenditures related with the sale might diminish its value, resulting in a smaller capital gain. By deducting these costs from the sale proceeds, you can lower your capital gain if you have a taxable capital gain as a result of having exceeded your exclusion or the property not being eligible.
You can’t deduct cleaning or maintenance charges, but there are a number of other selling expenditures that do qualify for deduction. In IRS Publication 523, you can minimize your capital gain by paying settlement fees, abstract fees, charges for installing utility service, legal expenses, recording fees, survey fees, transfer or stamp taxes, and owner’s title insurance. In the same way that you keep records and receipts for home repair projects, you should do the same for your taxes.
Suppose a married couple decides to sell their house for $700,000, as an example. 6% of the $700,000 is paid to the real estate broker ($42,000 x.06 = $42,000). They spend $18,000 on legal expenses, closing costs, escrow fees, and recording costs. A total of $60,000 was spent on their selling.
As a result, their net profit is $700,000 minus $60,000, which is $640,000. It costs them $140,000 to live in their own house. Capital gains for the company are $640,000 – $140,000 = $500,000.
Capital gains can be exempted from taxation for both of them if they fulfill the ownership and usage requirements. They would have had to pay $60,000 in capital gains tax if they hadn’t deducted the sale charges.
- Move Often
Taxpayers who sell their houses will be spared paying taxes because of the generous IRS capital gain exemption. In some cases, the exclusion may not cover all of your gains if you’ve owned your home for a long time, purchased in a hot market, or are single.
In order to maximize your utilization of the capital gain exclusion, tax expert David John Marotta says in Forbes that you should think about moving after you’ve exhausted your home’s capital gain exclusion. It is possible to claim the exclusion more than once even if you have resided in your home for at least two years before filing your tax return.
This means that you may be able to sell many properties at a high profit and not pay a penny in taxes.
Capital Gains on Investments Be Avoided
For assets like stocks, bonds, retirement funds, and rental properties, there are several tax-saving alternatives.
- Use a Retirement Account
A 401(k), regular IRA, or Roth IRA can help you avoid capital gains and postpone income taxes. If you have a 401(k) or conventional IRA, you can invest pre tax cash in the stock market. No capital gains tax is due on your earnings, but you will be subject to regular income tax when you take the money out. With a lower tax band in retirement, this strategy may save a lot of money.
The bottom of the income scale doesn’t always mean that you’ll be worse off after retirement. Your income from employment may reduce when you retire, but you may have additional income from Social Security, pensions, interest and dividends to make up for the loss of job income.
As a result, your effective tax rate may be the same as it was before retirement. Your taxable income may even climb if you have fewer possible deductions, such as student loan interest or mortgage interest, and if you can’t claim your child as a deduction.
A Roth IRA might help you avoid capital gains taxes if you’re uncertain about whether you’ll be in a lower tax band in retirement. Gains and dividends accrued in an IRA or 401(k) are not subject to taxation while the money is in the account.
Contributions to Roth IRAs are made after-tax, as opposed to pre-tax contributions to 401(k)s and regular IRAs. As a result, payouts from Roth IRAs are tax-free.
Contributing to a retirement account may result in a Saver’s Credit on your tax return, depending on your earnings.
- Gift Assets to a Family Member
In order to avoid paying 15% or 20% in capital gains taxes, consider donating the appreciated assets to a charity that has a lower capital gains tax rate. Taxpayers can give up to $16,000 per person, or $32,000 per couple, every year without having to submit a gift tax return with the IRS.
Investing in valued stock or other assets for the benefit of relatives in lower tax brackets may be an option in this case. It will be taxed at the rate of the family member selling the asset, not yours. A taxpayer may be able to avoid paying capital gains tax altogether under certain circumstances.
Family members might get financial help or presents while avoiding capital gains tax by using this method. Be aware, however, that this strategy does not function effectively when giving to youngsters or pupils less than 24 years old.
If their unearned income, such as capital gains or interest income, surpasses $2,200, these dependents must pay the same tax rates as their parents. When an asset is sold, the “Kiddie Tax,” as it’s commonly known, reverses any tax savings that were obtained.
- Donate to Charity
A substantial tax benefit and no capital gains taxes might be yours if you give an appreciated item to an organization you believe in. You can, in fact, take a tax deduction for the fair market value of a donated item.
Let’s imagine you paid $63 for 100 shares of Apple and then donated them to charity. Your starting point is $6,300. Let’s imagine the shares are valued at $120 after a 7-to-1 split. As a result, the total value of your shares is $84,000. When you donate shares, you get a tax deduction of $84,000, which is the fair market value at the time of the transaction.
There are no capital gains taxes to be paid on the $77,700 in capital gains. Charitable organizations are free from capital gains taxes, thus the charity doesn’t have to pay any.
The rich aren’t the only ones affected by capital gains tax. There are several simple methods that the average taxpayer may employ in order to reduce their capital gains tax burden. Consider consulting a tax expert if you want to use more intricate tax tactics, such as tax-loss harvesting or donating valuable shares.