Capital gains tax basics

If you are interested in selling an investment or real estate asset that has appreciated in value, it is important to understand capital gains tax and how it will affect your finances. Unlike ordinary income tax which applies to your earnings, capital gains tax is imposed on the profits that you make from selling capital assets.

A capital asset is basically anything that you own/use for personal or investment purposes. This can include stocks, bonds, home furnishings, and the home itself. When you sell a capital asset, the difference between your “basis” (usually the amount you paid for it) and what you sell it for is called a capital gain or loss. If you sell an asset for more than your basis, you have a capital gain.

No matter how long you have owned an asset, when you sell it for a profit you are making money. Your tax bracket and the amount of time that you hold the asset will determine how much you pay in capital gains tax.

Capital Gains Tax for Long-Term Assets

Long-term capital gains tax is enforced when you sell and profit from an asset that you’ve owned for over a year. Even for the highest income taxpayers, the maximum long term capital gains tax rate is 15%. Low-income individuals, classified as those in the 10% and 15% tax brackets, are not required to pay capital gains tax.

Capital Gains Tax for Short-Term Assets

Short-term gains are generally taxed at a higher rate than long-term gains.  Short-term capital gains tax is imposed when you sell and profit from something you have owned for one year or less. Short-term capital gains are taxed at the same rate as your ordinary income. As you may know, that tax rate can be as high as 35% depending on how much you earn.

Managing the Capital Gains Tax

The best way to manage your assets and reduce your capital gains tax is to keep a close watch on the calendar. Based on the information above, you can see that holding an asset for longer than a year before selling is generally more advantageous to your financial situation. If you sell an asset within a year, you will be subject to a higher (short-term) capital gains tax rate.

You may also consider offsetting your capital gains with capital losses. If you have more capital losses than gains, you can deduct the difference on your tax return to reduce your taxable income. There is a $3,000 annual deductible limit for taxpayers who are married filing jointly and a $1,500 annual limit if you file separately. Also note that capital losses can be carried over to the next year.

Avoiding capital gains tax altogether is probably not possible, but the more you understand about how gains and losses work, the better chance you have of saving money.

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