What is a capital gains tax?
A capital gain is the profit that is made from the sale of an asset.
A capital gains tax is a type of income tax charged on the money earned through the sale of the asset.
If you sell an asset for more than you paid for it, you must pay capital gains tax. This applies to both individuals and businesses.
You have capital gains when you sell the asset. It does not matter how the price has changed since you bought it.
Terms to know
Asset—The IRS considers almost anything with significant value to be an asset, even if it isn’t held as an investment. Example of assets:
- Investment real estate
- Your car
- Equipment or machinery
- Office equipment, computers, printers
Cost Basis—The starting value of the asset for tax calculation purposes, which is usually equal to what you originally paid for it.
Capital Gain—When you sell an asset for more than its cost basis, you have a capital gain. You must report this on your annual tax return.
Capital Loss—When you sell an asset for less than its cost basis, you have a capital loss. Individuals can deduct up to $3,000 in net capital losses from property held as investments—not for personal use—on their annual tax return. Additional losses can be carried over to the next tax year.
Determining the capital gains tax rate
The IRS divides capital gains tax rates into two categories, depending on how long you owned the asset.
Short term = less than one year
Long term = more than one year
Short Term—Assets owned for a year or less. Profit from the sale of short-term assets is taxed at the same rate as your regular income.
- All corporate capital gains are taxed at the applicable corporate income tax rate regardless of how long the investment is held.
Long Term—Assets owned for more than one year. For individuals, profit from the sale of most long-term assets is taxed at a reduced rate according to your regular income tax bracket:
|Regular Income Tax Rate||Long-Term Capital Gains Tax Rate|
- Long-term gains from the sale of collectibles, such as rare books, stamps, art, and fine wine, are taxed at a flat 28%.
Therefore, holding an investment for a longer period has significant tax benefits and is encouraged by lower tax rates.
Special rules for real estate
Although profit from the sale of real estate is still considered capital gain, you can minimize the amount of tax you pay in several ways. This makes real estate one of the more tax-friendly investments available.
- For any real estate you own, you can add additional expenses to your cost basis. Having a higher cost basis reduces your capital gain when you sell the property, which reduces your tax bill.
Qualifying expenses include:
- Closing costs, for example, legal fees and title fees
- Agent commissions
- Upgrades or improvements, such as new floors or a new roof
- Building additions, such as adding a garage
- If you sell your primary residence, you don’t have to pay taxes on up to $250,000 of capital gain. If you are married and file jointly, you can exclude up to $500,000. This does not apply to capital gain from the sale of investment property. You must live in the home to qualify.
- If you are selling an investment property, you can defer all taxation by using the proceeds to purchase another investment property through a 1031 Exchange.
- Immediately following World War I, the maximum capital gains tax rate was a whopping 77% for the richest Americans.
- Capital gains taxes reached historic lows from 1922 to 1933, when the maximum rate was just 12.5%.