Capital gains: Minimizing the capital gains tax
What are capital gains?
An increase in the worth of an investment, capital asset, or real estate is a capital gain. The growth makes its value higher than what you purchased it for. A capital loss, on the other hand, is a decrease in the value of an investment. You do not realize a gain or loss until you sell the asset. Once you sell an asset that has increased in value, the gain is realized and must be reported on your income tax return.
Your capital gains yield is the percentage of price appreciation of an investment. You can calculate the capital gains yield by dividing the rise in the stock’s price by the original price of the security at the time that you purchased it. For example, if you purchase an asset for $125 and sell it for $150, your yield is 20%.
A capital gain may be short-term or long-term. Short term capital gains are an increase in the price of an asset that you have held for 12 months or less. Long term capital gains are an increase in the worth of an asset that you have held for more than one year.
What are capital losses?
Capital losses occur when there has been a capital asset that you own has declined as compared to the price that you paid for it. You can claim capital losses as deductions on your tax return for the loss that you incurred when your capital asset decreased in value.
Like a capital gain, a capital loss is not realized until you sell the asset for a price that is lower than what you paid for it. A capital loss can help to offset a capital gain or other gains and can potentially help to reduce the capital gains tax that you might have to pay.
A capital loss for an asset that you have not sold is an unrealized loss. A capital loss is not reportable on your taxes until it is realized. When it is still an unrealized loss, it is simply a paper loss.
Capital gains tax
If you sell assets that you have held for more than one year and that are subject to the capital gains tax, your liability will depend on your income. The long term capital gains tax rate is 0%, 15%, or 20%, depending on your income. If you make $39,375 or less, you will not be assessed any tax on your capital gain. If you make between $39,376 to $434,550, your tax liability will be 15%. If you make more than that, the tax rate on your capital gain will be 20%.
If you realize a capital gain for an asset that you have held for 12 months or less, the short term capital gains tax will apply. These rates are equal to your ordinary income tax rate. In general, it is normally higher than the long term capital gains tax rates.
When you are figuring out your net asset value to calculate your capital gain, you will need to account for commissions and fees that you paid at the time that the asset was purchased. For property for which you have taken depreciation deductions in the past, there will also be a depreciation recapture at the time that you sell the assets. For clarity on depreciation tax rules, it is wise to consult your finance and tax professionals.
Statistics on capital gains and losses
According to the IRS, taxpayers reported more than $229 billion in gains and nearly $79 billion in losses on their corporate stock sales during the most recent year for which data is available. The Tax Policy Center reports that short term capital gains can be taxed up to 37% since they are taxed at the same rate as ordinary income. Long term capital gains can be taxed up to 20%.
During the most recent year for which data is available, U.S. taxpayers reported net capital losses of almost $21 billion. Capital losses can be claimed as deductions on your income tax return and can reduce the taxes that you might have to pay.
Realized vs. unrealized
When the value of an asset that you hold increases, your capital gain has not been realized. A realized capital gain is a taxable event that occurs only when you sell the asset. A realized capital loss similarly occurs when you sell an asset at a loss.
Unrealized gains and losses are known as paper gains and losses. They are increases or decreases in the investments’ values which do not trigger taxable events.
Capital gains tax
The taxes that you might have to pay for your capital gains will depend on several factors, including the length of ownership, your income level and ordinary income tax rate, exemptions that you might have, and offsets that you have available to you.
Short term capital gains occur on securities that you sell within one year or less of when you purchased them. They are taxed as ordinary income based on your tax filing status and adjusted gross income. If a short-term investment turns into a long-term investment by the time that it is sold, the taxes on your gain may be lower.
For long term capital gains, they are normally taxed at a rate that is lower than your ordinary income tax rate. Long term capital gains are taxed at a rate of 0%, 15%, or 20%. The highest tax bracket only pays a long term capital gains rate of 20%. Most people qualify for the 15% tax rate.
If you have a capital gain that is large compared to the rest of your income, it could trigger an alternative minimum tax. The alternative minimum tax is a federal income tax that is calculated separately and in addition to your ordinary income tax. The AMT is meant to prevent high-income taxpayers from taking advantage of certain deductions and credits to pay little or no taxes. You also need to take into account any depreciation recapture that might occur.
There is a big difference in what you pay in taxes if you hold your stock for longer periods of time. The government incentives investors to think long-term. For example, if you earn $85,000 per year, your ordinary income tax rate is 22%. If you realize a short-term capital gain, you will be taxed at 22% for it. If you hold the asset for longer than 12 months before you sell it and realize a gain, your capital gains tax will be 15% for a tax savings of 7%.
LONG TERM CAPITAL GAINS RATES
| Single taxpayers income | Married filing jointly income | Head of household income | |
|---|---|---|---|
| 0% | up to $39,375 | up to $78,750 | up to $52,570 |
| 15% | $39,376 to $434,550 | $78,751 to $488,850 | $52,571 to $461,700 |
| 20% | $434,551 or higher | $488,851 or higher | $461,701 or higher |
Capital assets can be tangible or intangible. They might include the following:
- Stocks
- Bonds
- Cars
- Boats
- Land
- Real estate
- Collectibles
- Antiques
- Art
- Jewelry
- Precious metals
For real estate, you can take depreciation deductions against the income to reflect the deterioration in the property’s value as it ages. When you take a depreciation deduction, it reduces your tax basis. Once you sell it, a portion of the capital gains is treated as a depreciation recapture.
It is called a depreciation recapture because it recollects some of the depreciation deductions that you have taken in the past. The tax rate that applies to the amount that is recaptured is 25%. Businesses must include their capital assets in their tax returns, including any expensive equipment that has a value that depreciates over time.
There are some exemptions that might apply. If you sell your primary residence, you might qualify to exclude a large percentage of your gain. To qualify, you must have lived in the home for at least two out of the past five years. Single people are able to exclude up to $250,000 of their capital gain, and married couples who file jointly may exclude up to $500,000 of their gain. You can only do this once in a five-year period.
If you are in the business of selling a particular asset, any profits that you make are treated as income earned in the ordinary course of business. The Potential Capital Gains Exposure is a percentage estimate of the appreciation of the assets in a fund. The PCGE represents gains and can be an indicator of potential future capital gains distributions.
Capital gains calculation
To calculate your capital gains, you first need to identify which assets have a capital gain or a capital loss. Take all of the investments and real estate that you sold during the year and determine the capital gain or capital loss for each one. Ignore any unrealized gain or unrealized loss because they do not figure into the calculation.
Separate the gains and losses into short- and long-term investments from their purchase dates. Offset your gains with your losses to arrive at your net gain or a net loss. If you have a gain in one category and a loss in the other, calculate each figure across both short- and long-term gains and losses. If you have gains in both, the tax rate will be different for your short- and long-term gains and must be kept separate.
Next, apply the tax rate for your short-term capital gains and your long-term capital gains. You can use a capital gain tax calculator here.
How are capital gains reported?
Realized capital gains for securities are reported on Form 1099-B to the IRS. Realized gains for funds are reported on Form 1099-DIV. Your brokerage must mail these forms to you and to the IRS by Feb. 15 of each tax year. The taxes on your capital sales will be due at the time that you file your income tax return.
Reduce capital gains
It is possible to reduce the taxes on your capital sales. One way is to plan ahead as to when you decide to sell a capital asset. To benefit from a lower capital gains tax rate, wait to sell a capital asset until a year or more has passed. Keep track of the date that you purchased each asset so that you can avoid making mistakes.
You want to aim to hold onto your investments for 12 months or longer. This allows your investments to change to the long-term capital gains tax rate. Only sell an asset in under a year if you have a good reason for needing to get rid of it.
When the year draws to an end, you can offset your capital losses with your gains through a process called tax-loss harvesting. Investors sell losing assets in order to offset their gains. You can only deduct losses against your capital gains of the same time length. In other words, short-term losses can only be deducted against short-term gains.
You are only allowed to deduct up to $3,000 of your net long-term losses in a single tax year. If you have excess net long-term capital losses, you can carry them forward until you have a sufficient capital gain income or until the $3,000 net long-term capital loss limitation is exhausted.
You can also try to offset your capital gains with your income. Wait to sell your higher-producing investments until you are in a lower income year.
If you make improvements to your home, keep records of them over time. You can report them at the time of your sale to help to minimize the capital gain by reducing the net asset value of the home. If you sell your primary residence, use the exclusion to minimize your capital gains tax. This might mean waiting to sell your home at the right time.
Charitable contributions can help to reduce the taxes that you might have to pay. If you make contributions during the same year in which you sell a capital asset, you can claim the charitable contribution as a tax deduction. This reduces your taxable income and can reduce the amount that you owe in income taxes.
Finally, take advantage of retirement accounts that have tax-free or tax-deferred investments. These include IRAs, 401(k)s, 403(b)s, and 457 plans.
Tax-efficient investing with M1 Finance
Minimizing your net investment income tax is an important goal and is possible by timing your capital gains and the duration that you hold your securities. M1 Finance also can help with its tax minimization and optimization strategies.
M1 Finance is a top reviewed brokerage that allows you to transfer your tax-free or tax-deferred IRA account while spending nothing on fees. It offers award-winning investment tools that allow your money to automatically grow while minimizing your net investment income tax.
To reduce your capital gains yield, M1 uses built-in tax efficiency so that you might pay less on your taxes automatically. You can invest in your IRA without paying all of the costs, commissions, and fees because investing with M1 Finance is free.
When you open your account, you can create a custom portfolio by selecting your own securities and the weights to assign to each one. If you feel more comfortable with choosing a portfolio that has been created for you by an expert, we have more than 80 portfolios that have been tailored for different financial goals, durations, and levels of risk tolerance. M1 also offers rollovers all of your current IRAs and 401ks for free.
The design of the M1 Finance platform makes investing accessible to all types of investors. You can access its powerful automation anytime and anywhere. The platform combines automated reinvestment and dynamic rebalancing, which help your portfolio to continue working towards your goals automatically. With M1 Finance, you can build wealth effortless by taking advantage of its powerful technology.
Tax and Legal Advice Disclaimer. M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.