What Is the Capital Gains Tax?
The capital gains tax is the levy on the profit that an investor makes when an investment is sold. It is owed for the tax year during which the investment is sold. The long-term capital gains tax rates for the 2021 and 2022 tax years are 0%, 15%, or 20% of the profit, depending on the income of the filer.
An investor will owe long-term capital gains tax on the profits of any investment owned for at least one year. If the investor owns the investment for one year or less, short-term capital gains tax applies. The short-term rate is determined by the taxpayer’s ordinary income bracket. For all but the highest-paid taxpayers, that is a higher tax rate than the capital gains rate.
Definitions and Examples of the Capital Gains Tax
The capital gains tax only becomes due once you sell your investment. For example, you won’t owe tax while stock gains value inside your portfolio. However, once you sell your shares, the profit must be reported on your tax return. As a result, you pay a tax on your profit at the capital gains rate.
The federal government taxes all capital gains. Short-term capital gains or losses occur when you’ve owned an asset for a year or less. Long-term capital gains or losses occur if you sell an asset after owning it for longer than one year.
Short-term capital gains have a higher tax rate than long-term capital gains.1 This difference is deliberate to discourage short-term trading. Trading stocks and other assets frequently can increase market volatility and risk. It also costs more in transaction fees to individual investors.
Understanding the Capital Gains Tax
When stock shares or any other taxable investment assets are sold, the capital gains, or profits, are referred to as having been “realized.” The tax doesn’t apply to unsold investments or “unrealized capital gains.” Stock shares will not incur taxes until they are sold, no matter how long the shares are held or how much they increase in value.
Under current U.S. federal tax policy, the capital gains tax rate applies only to profits from the sale of assets held for more than a year, referred to as “long-term capital gains.” The current rates are 0%, 15%, or 20%, depending on the taxpayer’s tax bracket for that year.
Most taxpayers pay a higher rate on their income than on any long-term capital gains they may have realized. That gives them a financial incentive to hold investments for at least a year, after which the tax on the profit will be lower.
Day traders and others taking advantage of the ease and speed of trading online need to be aware that any profits they make from buying and selling assets held less than a year are not just taxed—they are taxed at a higher rate than assets that are held long-term.
Taxable capital gains for the year can be reduced by the total capital losses incurred in that year. In other words, your tax is due on the net capital gain. There is a $3,000 maximum per year on reported net losses, but leftover losses can be carried forward to the following tax years.
Capital Gains Tax Rates for 2021 and 2022
The profit on an asset that is sold less than a year after it is purchased is generally treated for tax purposes as if it were wages or salary. Such gains are added to your earned income or ordinary income on a tax return.
The same generally applies to dividends paid by an asset, which represent profit although they aren’t capital gains. In the U.S., dividends are taxed as ordinary income for taxpayers who are in the 15% and higher tax brackets.
A different system applies, however, for long-term capital gains. The tax you pay on assets held for more than a year and sold at a profit varies according to a rate schedule that is based on the taxpayer’s taxable income for that year. The rates are adjusted for inflation each year.
The rates for tax years 2021 and 2022 are shown in the tables below:
|2021 Tax Rates for Long-Term Capital Gains|
|Single||Up to $40,400||$40,401 to $445,850||Over $445,850|
|Head of household||Up to $54,100||$54,101 to $473,750||Over $473,750|
|Married filing jointly and surviving spouse||Up to $80,800||$80,801 to $501,600||Over $501,600|
|Married filing separately||Up to $40,400||$40,401 to $250,800||Over $250,800|
|2022 Tax Rates for Long-Term Capital Gains|
|Single||Up to $41,675||$41,675 to $459,750||Over $459,750|
|Head of household||Up to $55,800||$55,800 to $488,500||Over $488,500|
|Married filing jointly and surviving spouse||Up to $83,350||$83,350 to $517,200||Over $517,200|
|Married filing separately||Up to $41,675||$41,675 to $258,600||Over $258,600|
The tax rates for long-term capital gains are consistent with the trend to capital gains being taxed at lower rates than individual income, as this table demonstrates.
Special Capital Gains Rates and Exceptions
Some categories of assets get different capital-gains tax treatment than the norm.
Gains on collectibles, including art, antiques, jewelry, precious metals, and stamp collections, are taxed at a 28% rate regardless of your income. Even if you’re in a lower bracket than 28%, you’ll be levied at this higher tax rate. If you’re in a tax bracket with a higher rate, your capital gains taxes will be limited to the 28% rate.1
Owner-Occupied Real Estate
A different standard applies to real estate capital gains if you’re selling your principal residence. Here’s how it works: $250,000 of an individual’s capital gains on the sale of a home are excluded from taxable income ($500,000 for those married filing jointly).
This applies so long as the seller has owned and lived in the home for two years or more.
However, unlike with some other investments, capital losses from the sale of personal property, such as a home, are not deductible from gains.
Here’s how it can work. A single taxpayer who purchased a house for $200,000 and later sells his house for $500,000 had made a $300,000 profit on the sale. After applying the $250,000 exemption, this person must report a capital gain of $50,000, which is the amount subject to the capital gains tax.
In most cases, the costs of significant repairs and improvements to the home can be added to its cost, thus reducing the amount of taxable capital gain.
Investment Real Estate
Investors who own real estate are often allowed to take depreciation deductions against income to reflect the steady deterioration of the property as it ages. (This is a decline in the home’s physical condition and is unrelated to its changing value in the real estate market.)
The deduction for depreciation essentially reduces the amount you’re considered to have paid for the property in the first place. That in turn can increase your taxable capital gain if you sell the property. That’s because the gap between the property’s value after deductions and its sale price will be greater.
Example of Depreciation Deduction
For example, if you paid $100,000 for a building and you’re allowed to claim $5,000 in depreciation, you’ll be taxed as if you’d paid $95,000 for the building. The $5,000 is then treated in a sale of the real estate as recapturing those depreciation deductions.
The tax rate that applies to the recaptured amount is 25%. So if the person then sold the building for $110,000, there would be total capital gains of $15,000. Then, $5,000 of the sale figure would be treated as a recapture of the deduction from income. That recaptured amount is taxed at 25%. The remaining $10,000 of capital gain would be taxed at 0%, 15%, or 20%, depending on the investor’s income.8
If you have a high income, you may be subject to another levy, the net investment income tax.
This tax imposes an additional 3.8% of taxation on your investment income, including your capital gains, if your modified adjusted gross income or MAGI (not your taxable income) exceeds certain maximums.
Those threshold amounts are $250,000 if married and filing jointly or a surviving spouse; $200,000 if you’re single or a head of household, and $125,000 if married, filing separately.9
Calculating Your Capital Gains
Capital losses can be deducted from capital gains to calculate your taxable gains for the year.
The calculation becomes a little more complex if you’ve incurred capital gains and capital losses on both short-term and long-term investments.
First, sort short-term gains and losses in a separate pile from long-term gains and losses. All short-term gains must be reconciled to yield a total short-term gain. Then the short-term losses are totaled. Finally, long-term gains and losses are tallied.10
The short-term gains are netted against the short-term losses to produce a net short-term gain or loss. The same is done with the long-term gains and losses.10
Capital Gains Tax Strategies
The capital gains tax effectively reduces the overall return generated by the investment. But there is a legitimate way for some investors to reduce or even eliminate their net capital gains taxes for the year.
The simplest of strategies is to simply hold assets for more than a year before selling them. That’s wise because the tax you will pay on long-term capital gains is generally lower than it would be for short-term gains.1
1. Use Your Capital Losses
Capital losses will offset capital gains and effectively lower capital gains tax for the year. But what if the losses are greater than the gains?
Two options are open. If losses exceed gains by up to $3,000, you may claim that amount against your income. The loss rolls over, so any excess loss not used in the current year can be deducted from income to reduce your tax liability in future years.11
For example, say an investor realizes a profit of $5,000 from the sale of some stocks but incurs a loss of $20,000 from selling others. The capital loss can be used to cancel out tax liability for the $5,000 gain. The remaining capital loss of $15,000 can then be used to offset income, and thus the tax on those earnings.
So, if an investor whose annual income is $50,000 can, in the first year, report $50,000 minus a maximum annual claim of $3,000. That makes a total of $47,000 in taxable income.
The investor still has $12,000 of capital losses and can deduct the $3,000 maximum every year for the next four years.
2. Don’t Break the Wash-Sale Rule
Be mindful of selling stock shares at a loss to get a tax advantage and then turning around and buying the same investment again. If you do that in 30 days or less, you will run afoul of the IRS wash-sale rule against this sequence of transactions.12
Material capital gains of any kind are reported on a Schedule D form.13
Capital losses can be rolled forward to subsequent years to reduce any income in the future and lower the taxpayer’s tax burden.
3. Use Tax-Advantaged Retirement Plans
Among the many reasons to participate in a retirement plan like a 401(k)s or IRA is that your investments grow from year to year without being subject to capital gains tax. In other words, within a retirement plan, you can buy and sell without losing a cut to Uncle Sam every year.
Most plans do not require participants to pay tax on the funds until they are withdrawn from the plan. That said, withdrawals are taxed as ordinary income regardless of the underlying investment.
The exception to this rule is the Roth IRA or Roth 401(k), for which income taxes are collected as the money is paid into the account, making qualified withdrawals tax-free.14
4. Cash in After Retiring
As you approach retirement, consider waiting until you actually stop working to sell profitable assets. The capital gains tax bill might be reduced if your retirement income is lower. You may even be able to avoid having to pay capital gains tax at all.1
In short, be mindful of the impact of taking the tax hit when working rather than after you’re retired. Realizing the gain earlier might serve to bump you out of a low- or no-pay bracket and cause you to incur a tax bill on the gains.
5. Watch Your Holding Periods
Remember that an asset must be sold more than a year to the day after it was purchased in order for the sale to qualify for treatment as a long-term capital gain. If you are selling a security that was bought about a year ago, be sure to check the actual trade date of the purchase before you sell. You might be able to avoid its treatment as a short-term capital gain by waiting for only a few days.
These timing maneuvers matter more with large trades than small ones, of course. The same applies if you are in a higher tax bracket rather than a lower one.
6. Pick Your Basis
Most investors use the first-in, first-out (FIFO) method to calculate the cost basis when acquiring and selling shares in the same company or mutual fund at different times.
However, there are four other methods to choose from: last in, first out (LIFO), dollar value LIFO, average cost (only for mutual fund shares), and specific share identification.
The best choice will depend on several factors, such as the basis price of shares or units that were purchased and the amount of gain that will be declared. You may need to consult a tax advisor for complex cases.
Computing your cost basis can be a tricky proposition. If you use an online broker, your statements will be on its website. In any case, be sure you have accurate records in some form.
Finding out when a security was purchased and at what price can be a nightmare if you have lost the original confirmation statement or other records from that time. This is especially troublesome if you need to determine exactly how much was gained or lost when selling a stock, so be sure to keep track of your statements. You’ll need those dates for the Schedule D form.
When Do You Owe Capital Gains Taxes?
You owe the tax on capital gains for the year in which you realize the gain. For example, if you sell some stock shares anytime during 2022 and make a total profit of $140, you must report that $140 as a capital gain on your tax return for 2022.
Capital gains taxes are owed on the profits from the sale of most investments if they are held for at least one year. The taxes are reported on a Schedule D form.
The capital gains tax rate is 0%, 15%, or 20%, depending on your taxable income for the year. High earners pay more. The income levels are adjusted annually for inflation. (See the tables above for the capital gains tax rates for the 2021 and 2022 tax years.)
If the investments are held for less than one year, the profits are considered short-term gains and are taxed as ordinary income. For most people, that’s a higher rate.
How Can You Avoid Capital Gains Taxes?
If you want to invest money and make a profit, you will owe capital gains taxes on that profit. There are, however, a number of perfectly legal ways to minimize your capital gains taxes:
- Hang onto your investment for more than one year. Otherwise, the profit is treated as regular income and you’ll probably pay more.
- Don’t forget that your investment losses can be deducted from your investment profits, at a rate of up to $3,000 a year. Some investors use that fact to good effect. For example, they’ll sell a loser at the end of the year in order to have losses to offset their gains for the year.
- If your losses are greater than $3,000, you can carry the losses forward and deduct them from your capital gains in future years.
- Keep track of any qualifying expenses that you incur in making or maintaining your investment. They will increase the cost basis of the investment and thus reduce its taxable profit.