The government levies taxes on most income-generating activities. Investing and selling assets are income-generating activities, making the proceeds taxable under the capital gains tax. Here is a brief guide on how the capital gains tax works and tips to reduce your taxes.
What Is Capital Gains Tax?
Capital gains tax is a tax levied on income gained from selling assets at a profit – that is, at a price higher than the basis. The tax applies to a wide range of assets, including:
- Real estate property
- Precious metals (including gold and silver)
- Collectibles (including stamps and coins)
- Household furnishings
- Timber harvested on your personal or investment property
However, some commercial assets, such as business inventory and depreciable business property, are not taxable under the capital gains tax. Self-created intangible assets such as music, patents, and copyrights are also exempt from this tax. It is also worth noting that not all transactions on real estate property are liable for taxation under the capital gains tax.
Capital Gains Tax Rates
Capital gains tax rates depend on the period spent holding the taxable asset and are categorized as long-term and short-term. Short-term capital gains apply to assets held for a maximum of one year, while long-term capital gains apply to assets held for longer than one year. Notably, short-term capital gains tax rates are usually higher than long-term ones.
The government adjusts capital gains tax rates periodically. Currently, the government has capped short-term capital gains rates at 37% and long-term ones at 20%. Long-term capital gains rates have three margins (0%, 15%, and 20%), while short-term ones have seven margins (10%, 12%, 22%, 24%, 32%, 35%, and 37%).
Capital gains tax rates vary depending on several factors, primarily the income gained from selling the asset. Profits that fall below a certain amount are not taxed. Notably, high incomes on some taxable assets are also liable for additional taxation under the net investment income tax. Your familial status (whether you are single, married, separated, or widowed) also determines the applicable capital gains tax rate.
How to Calculate Capital Gains Tax
Calculating your capital gains tax is relatively simple, as described in the following step-by-step process:
- Step 1: Determine the asset’s basis (its purchase price).
- Step 2: Calculate the realized profit (the sale price minus the basis).
- Step 3: Calculate the tax by multiplying the realized profit (capital gain) by the appropriate tax rate.
It is also worth noting that you can use capital losses on some assets to offset capital gains on other assets. Overall, it is advisable to consult a professional when calculating and returning capital gains taxes.
Tips to Lower Your Capital Gains Tax
Fortunately, there are several ways to reduce your capital gains taxes. The most effective tactics include:
- Making long-term investments (short-term investments are taxed at higher rates).
- Taking advantage of tax-deferred retirement plans, such as 401k and IRA plans.
- Offsetting capital gains on profitable assets using capital losses on non-profitable ones.
Investors making multiple investments in the same asset can also lower their tax rates by determining each asset’s cost basis. Cost basis is applicable when you buy some assets today at one price and additional assets on a later date at another price.
Capital tax gains apply to most assets sold at a profit. However, whether or not your transaction is liable for the capital gains tax (and if so, the applicable capital gains tax rate) depends on many factors. Overall, it is advisable to do your homework before filing your taxes. When in doubt, consult with an experienced financial professional to understand your tax obligations.