LUTZ BUSINESS INSIGHTS
understanding capital gains tax
joe donovan, tax director
What is a Capital Gain?
To understand capital gains tax and how it may apply to you, it is crucial to first know what qualifies as a capital gain. A capital gain occurs when a taxpayer sells a capital asset where they have realized an increase in that asset’s value. Capital assets are considered significant pieces of property like homes, cars, investment real estate, stocks, or bonds. When a taxpayer sells a piece of property for more than their basis (generally what they initially paid), the difference is a capital gain.
While realizing capital gains is a wonderful thing, it is important to consider the tax implications of capital gains. The tax implications that apply to each situation depend on various factors, including what is being sold and how long the taxpayer held the asset.
The most common capital assets bought and sold by taxpayers are publicly traded securities like stocks and bonds. When selling publicly traded securities, the main consideration a taxpayer needs to be aware of prior to realizing a gain is their holding period. If a taxpayer has held the asset for more than one year, the gain is subject to the lower capital gains tax rates. If they hold it for a year or less, the gain is treated as a short-term capital gain, which is taxed at their ordinary income rates. Taxpayers can also take advantage of these preferential capital gains tax rates on certain types of qualified dividends.
Taxpayers should also be aware that, depending on their level of “investment income,” they may be subject to an additional tax – the “net investment income tax.” Investment income generally includes interest payments, dividends, and capital gains. This tax, imposed by the IRS in 2013, generally is a 3.8% tax on realized investment income when their adjusted gross income is above the below thresholds.
- Married individual filing jointly – $250,000 per year joint income
- Married individual filing separately – $125,000 per year income
- Single OR Head of Household – $200,000 per year income
- Qualifying Widow(er) with a child – $250,000 per year income
Knowing where your investment income falls, and if you are subject to the net investment income tax is important for tax planning and managing your tax exposure.
An often-overlooked capital asset that is treated differently from capital gains on publicly traded securities is gains from the sale of collectible property like art collections, antique furniture, and similar items. Capital gains earned from the sale of collectibles face a higher capital gains tax rate of up to 28%. Similar to the sale of publicly traded securities, the amount of capital gain earned through collectible sales is based on comparing the basis (generally purchase price including any fees as well as costs incurred for restoration) and the price the seller received when the item was sold.
Another asset that can lead to capital gain is the sale of real estate, both investment properties and primary residences alike.
Investment Real Estate
Investment real estate is generally considered any real estate that is not the owner’s primary residence or was purchased as an investment to yield a return. Tax on the sale of investment real estate is more complicated than the sale of publicly traded securities. The reason for this is your original basis is often reduced during your ownership of the property by deducting what is known as depreciation expense. The tax upon sale of the real estate will be taxed at different rates based on what depreciation has been taken and how much the real estate has appreciated. This is a complex topic, and if you are considering selling real estate, you should consult your tax advisor.
Sale of Primary Residence
While the sale of a primary residence is still subject to capital gains tax, the IRS allows for substantial exclusions from capital gains tax on the sale of a primary residence, making a realized gain on the sale of a primary residence more rare. The current exemptions are as follows:
- $250,000 if the seller is single
- $500,000 if the seller is married and files taxes jointly
In order to qualify for these exemptions, you must meet certain standards – namely, it must have been your primary residence for two of the previous five years.
Capital Gains Tax Rate
Now that we have discussed some examples of different types of capital gains, it is important to understand what tax rates will apply when you sell a capital asset. As discussed above, a short-term capital gain occurs when a taxpayer sells an asset they held for a year or less, while a long-term capital gain refers to the sale of an asset held longer than a year. Short-term capital gains are taxed at a taxpayer’s ordinary rate. Long-term capital gains are subject to lower preferential rates below:
- 0% for individuals with a yearly income of $0 – $40,000, or married individuals filing jointly with a yearly income of $0 – $80,000
- 15% for individuals with a yearly income of $40,001 – $441,450, or married individuals filing jointly with a yearly income of $80,001 – $496,600
- 20% for individuals with a yearly income of $441,451, or married individuals filing jointly with a yearly income of $496,601
There are complex rules for netting your short-term and long-term capital gains. If you are in a situation where you have both long-term and short-term gains in the same year, you should consult your tax adviser.
Planning for Capital Gains Tax
There are many strategies that can help you prepare for and minimize the effects of capital gains tax. Consulting with an accounting and tax professional can help you manage the tax impact of selling capital assets. There are a couple of important concepts that taxpayers should be aware of.
Capital Loss Carry Forward
Unfortunately for taxpayers, the IRS does not allow you to deduct more than $3,000 of capital losses in any given year. Note that you can offset capital gains with capital losses (see tax loss harvesting below). If you are in a situation where your capital losses exceed your capital gains, you will be allowed to offset future realized capital gains incurred. If no capital gains are realized in a year where you have a capital loss carryforward from a prior year, you will be able to deduct the $3,000 mentioned above.
Tax Loss Harvesting
Tax loss harvesting is a strategy investors can use to offset capital gains they have incurred during a tax year. If a taxpayer has realized capital gains during the year, it may make sense to review their other capital holdings and see if they have any unrealized losses they would be comfortable selling. If they sell the asset in the same tax year as the realized gains, the two can be netted together to help minimize the tax impact of the capital gain. It is important to note that you cannot sell an asset and immediately buy it back (this is known as a wash sale). When looking to execute a strategy like Tax Loss Harvesting, it is important that you consult your tax advisor to make sure these complex rules are not tripping you up.
In summary, it is important to understand the tax implications of a capital gains sale to ensure you get the most value. Consult with a tax professional to determine the best way to leverage these strategies and minimize the effects capital gains tax may have on your investments in the long run. Contact Lutz today to learn how we can help.
ABOUT THE AUTHOR
JOE DONOVAN + TAX DIRECTOR
Joe Donovan is a Tax Director at Lutz with over six years of experience in taxation. He primarily focuses his time on tax compliance, research, and consulting assistance to privately held companies in a variety of industries including real estate development and construction.
AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
- American Institute of Certified Public Accountants, Member
- Nebraska Society of Certified Public Accountants, Member
- Certified Public Accountant
- BSBA in Accounting, University of Notre Dame, Notre Dame, IN
- Masters in Science of Accountancy, University of Notre Dame, Notre Dame, IN
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