If you're reading about capital gains, it likely means that your investments have been performing well. Or perhaps you're preparing for the future when they do. In either case, understanding capital gains and taxes is crucial for financial planning.
What Are Capital Gains?
Capital gains are the profits you make when you sell investments such as stocks or real estate. These gains can be classified as either short-term or long-term, depending on the holding period of the investment. Short-term gains apply to assets held and sold within one year, while long-term gains apply to assets held for over a year.
When the value of your assets exceeds what you initially paid for them, you may consider selling some to realize those capital gains. However, it's important to note that you only pay capital gains taxes after selling an investment. This means the money you make from an investment is subject to federal and state taxation.
How Much Will I Pay in Capital Gains Taxes?
The amount you pay in capital gains taxes depends on various factors, including the duration of asset ownership and your income tax bracket. Long-term capital gains are generally taxed at lower rates than short-term gains.
Tax rates for long-term capital gains can be as low as 0%, even for taxpayers in the top income tax bracket. The rates for short-term capital gains align with regular income tax rates.
To determine your capital gains tax liability, you need to know your basis, which is the amount you paid for the asset. Your tax liability is calculated based on the difference between the sale price of the asset and its basis.
Lowering Capital Gains Taxes with Tax-Loss Harvesting
Tax-loss harvesting is a strategy that allows investors to minimize their capital gains taxes. By offsetting capital gains from profitable investments with losses from depreciated assets, you can reduce your tax liability.
However, tax-loss harvesting can be complex and requires careful consideration. Some argue that it might not be beneficial in the long run, as it involves selling assets that could appreciate in the future. Additionally, changes to the tax code could affect the tax implications of this strategy.
State Taxes and Capital Gains
In addition to federal taxes, some states also levy taxes on capital gains. The tax rates at the state level are typically aligned with regular income tax rates. States with high income taxes, such as California, New York, and Oregon, also have higher taxes on capital gains.
Capital Gains Taxes on Property
If you own a home, you might be wondering how capital gains taxes apply to property sales. Similar to other assets, the capital gains on a home are calculated based on the difference between the sale price and your basis.
When selling your primary residence, up to $250,000 of capital gains (or $500,000 for couples) may be exempted from taxation. This exemption applies if you have owned and used the home as your primary residence for at least two out of the five years prior to the sale.
If you inherit a home, the rules differ. Inheriting a home grants you a "step-up in basis," which means your basis is adjusted to the market value at the time of inheritance. This can result in significant tax advantages when selling the inherited property.
Net Investment Income Tax (NIIT)
Under certain circumstances, the Net Investment Income Tax (NIIT) may be applicable to income from investments. NIIT is calculated based on your net investment income and modified adjusted gross income (MAGI), subject to specific thresholds. The tax rate for NIIT is 3.8%.
Net investment income includes interest, dividends, capital gains, rental income, and more. The NIIT applies only to U.S. citizens and resident aliens, while nonresident aliens are exempt from this tax.
Understanding capital gains and the associated taxes is essential for managing your investments effectively. By leveraging strategies like tax-loss harvesting and considering state-specific regulations, you can optimize your tax liability. Consult a financial advisor to navigate the complexities of capital gains taxes and make informed decisions for your financial future.