What Is Capital Gains Tax and When Are You Exempt?

As tax season approaches, you're going to need to compile all the information about your finances that you possibly can. Your yearly income isn't the only thing you'll need.

If you're an investor, or even if you've just made a profit on a sale, the gains you make will play a sizable role in the taxes you pay - regardless of when something was bought or sold. The gains and losses affect your income and how much you'll be taxed.

So what is the capital gains tax, how does it affect you, and when can your assets be exempt from it?

What Is the Capital Gains Tax?

Capital gains tax is the tax imposed by the IRS on the sale of certain assets. For investors, this can be a stock or a bond, but if you make a profit on selling a car that is also a capital gain that you will need to account for.

With investments, many may assume the capital gains tax only matters for the ultra-wealthy, making major profit off of their stock portfolio. But if you sold a large personal item from your home (or even your home itself) and made profit, that may be a capital gain that will be taxed as such.

Capital Losses

Capital gains sound nice, since making a profit is always a good thing. But it's also not a guarantee on any sale. What if you sell your shares in a company when they're down because you think the price will fall even further?

That would be a capital loss. Capital losses are not ideal, but if you've made capital gains on the sale of a different asset that same year, you may be able to use the loss to your advantage.

The subtraction of capital losses from capital gains is known as the net capital gain. That means one can offset the other, whether it's a gain offsetting a loss to make sure you still have a profit or a loss offsetting a gain to help pay less of a capital gains tax that year.

To put it into numbers, let's say you have $5,000 of shares in one company and $2,000 of shares in another business. Now let's say you sell high on the first company and make $6,500, and sell low on the second company for $1,500. Your capital gain on one was $1,500 and your capital loss on the other was $500, giving you a net capital gain of $1,000 that would be taxed accordingly.

Long-Term vs. Short-Term Capital Gains

Another thing that will impact your capital gains tax is whether it is a long-term capital gain or a short-term capital gain. Each is taxed differently. In the example above, if one of those sales was a short-term capital gain and the other was long term, they would have to be taxed differently.

Whether the gain is long term or short term is, fittingly, based on how long it was that you owned the asset. A short-term capital gain comes from the sale of any asset that was owned for less than one year. Long-term capital gains are from assets owned for over a year.

The time length may not seem important, but it can play a huge role in how much you pay in taxes. If a short-term investment becomes a long-term investment, by the time you sell the asset, you could be paying less taxes on the gains you make. Short-term capital gains get taxed at a standard rate based on your income bracket; long-term capital gains, not so much.

What Is the Capital Gains Tax Rate in 2018?

In 2018, the brackets a household is put in based on their income indicates if they are being paid at a larger or smaller rate; from least income to most income a household could have a tax rate of 10%, 12%, 22%, 24%, 32%, 35% and 37%. For a single individual filing their taxes, to have a rate of 37% you would need to have a yearly income of more than $500,000. A married couple filing joint taxes together would need to make more than $600,000 to be included in that highest tax bracket, while a married individual filing separately would need more than $300,000 in yearly income.

When this gets complicated is when long-term capital gains are taken into account. As opposed to being in line with standard tax brackets, long-term capital gains are either taxed at a rate of 0%, 15% or 20%.

And it does not line up entirely with short-term rates either; much of the households in the 12% income bracket have a 0% tax rate for long-term gains, but hitting a certain threshold (over $38,600 for individuals, over $77,200 for joint married couples) means being taxed at a 15% rate. Similarly, the lower end of the 35% bracket is taxed at a 15% rate for long-term gains, but the higher end is taxed at 20%.

This means that patience can potentially help out your taxation quite a bit. Someone in the 24% tax bracket would only be paying a 15% rate on a long-term capital gain.

What Assets Can Get Taxed and What Is Exempt?

If you're just now being made aware of the capital gains tax, you'll need to know the specific assets that get taxed under the capital gains tax.

These assets can be tangible and intangible, something that can potentially generate value over a period of time. This is known as a "capital asset."

Some items, both tangible and intangible, that can count as a capital asset include:

  • Stocks
  • Bonds
  • Cars
  • Boats
  • Land and real estate properties

These are mostly in the case of an individual or married couple filing their taxes. Businesses also have to factor capital assets into their taxes, which can include expensive equipment whose value can depreciate over time.

Some capital assets, though, can be exempt depending on the circumstances. This applies most often to real estate. You'll need to check if your primary residence qualifies for excluding a large percentage of your gain from the capital gains tax.

In addition to needing to be your primary residence, you will need to have lived in the house for at least two of the past five years. Single people can qualify for up to $250,000 of their capital gain being exempt, while married couples can have $500,000 excluded. However, this can only be done once in a five-year span.

Minimizing Capital Gains Taxes

Some of the simplest ways to minimize capital gains taxes have already been mentioned. Waiting until something becomes a long-term capital gain can, for most, decrease the tax rate quite a bit. Someone in the uppermost tax bracket can go from a 37% tax rate on a capital gain to a 20% rate; in the lowest brackets, a 10%-12% tax rate can turn into 0%.

Successfully getting your primary residence excluded is the largest way to minimize your capital gains tax, but even if you have to pay a tax on your real estate gains there are ways to minimize those. Keeping records of the various improvements you made to your home and reporting them along with the sale can minimize the capital gain.

Looking to reduce your capital gains taxes is also when some of those capital losses can come in handy - provided you have more capital gains that year, of course. Combining them into a lower net capital gain means less income getting taxed.

Criticism of Capital Gains Tax

One of the biggest criticisms of the capital gains tax is that it is simply a way for the wealthy to pay less in taxes. An ultra-wealthy investor who's entire income stems from their stocks can only have a 20% tax rate instead of a 37% rate. The ability of someone in the highest possible tax bracket to pay 20% in taxes on a major gain while someone in the middle-class pays 24% on their general taxes can easily create further wealth inequality in America.

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