Why are capital gains taxes important?
Capital gains tax liability is created when you sell just about any asset at a gain. You can minimize the taxes on a sale by understanding capital gains taxes and planning. By holding an asset for longer than a year, the gain on the sale will usually be taxed at lower rates (gains may be tax free in limited circumstances.)
What are Capital Gains?
Capital gains are the gains on the sale of almost any capital asset. The gain is figured by subtracting the basis (cost) of an asset from the sale proceeds.
Basis is the cost of the asset plus certain transaction costs minus any depreciation taken or allowable. (Special rules apply for determining the basis of inherited or gifted property)
What are Capital Assets?
Capital assets are both investment type assets and personal use assets. They include stocks, bonds, homes, cars, artwork, cell phone, and just about anything you own. We are focusing on stocks, bonds, and securities for this article.
To get the preferable long term capital gains tax rates, generally the asset must be held for more than one year. To prevent people from gaming the system by selling and rebuying an asset, the IRS has instituted wash sale rules, covered below.
Long Term Capital Gains Rates for Income and Filing Status
Long term capital gains float on top of ordinary income and then are taxed at long term gain rates. Short term gains are taxed at ordinary income rates. There are exceptions and different rates for certain depreciation recapture and specific asset types.
The below table shows the 2021 tax rate on long term gains for different total income ranges. Not all long term gains are taxed as the same rate. As total income, which is ordinary income plus long term gains, climbs, the tax rate on the portion of long term gains in a given bracket increases. When taxable income exceeds the 0% range, any amounts over the 0% limit are taxed at 15% up to the maximum of that range. Any amounts exceeding the 15% total income range are taxed at 20%.
|Single||Up to $40,400||$40,401-$445,850||Over $445,850|
|Married Filing Jointly||Up to $80,800||$80,801-$501,600||Over $501,600|
|Married Filing Separately||Up to $40,400||$40,401-$250,800||Over $250,800|
|Head of Household||Up to $54,100||$54,101-$473,750||Over $473,750|
25%: Certain property depreciation recapture
28%: Collectibles held more than one year, qualified small business stock held more than 5 years. Small business stock gains may be eligible for partial exclusion depending on when purchased.
Capital Losses and Netting Process
Capital losses can be used to offset capital gains for tax purposes. The netting process sets a sequence to calculate the net taxable gain.
In the netting process, first determine the net short term gain (loss) and the net long term gain (loss). If both categories yield a net loss, they are combined to determine the total net capital loss. If both categories, long term and short term show a net gain, they are both included in net income and taxed at the applicable rates.
If one category has a net loss and the other a gain, the loss can be used to reduce the taxable gain of the profitable category.
Finally, taxpayers can use any remaining net loss, up to $3,000 ($1,500 for married couples filing separately), to offset ordinary income. Net capital losses in excess of these limits can be carried forward to the following year, subject to the same rules and retaining their characterization of long term or short term loss.
The process becomes significantly more complex if 25 and 28% property is included, and will not be covered here.
To limit people harvesting losses and then repurchasing the same or equivalent asset, the IRS imposes wash sale rules. It is considered a wash sale if an investor sells a security or asset at a loss, and within 30 days before or after the sale purchases substantially the same asset. Any losses which cannot be recognized under the wash sale rules get added to the basis of the newly acquired asset, potentially reducing a future gain.
First In, First Out (FIFO)
If you have made multiple purchases of the same asset at different times, the IRS says the first lots purchased are the first sold, unless otherwise specified before the sale. This frequently comes into play with stocks.
Suppose you bought:
200 Shares of Apple on 3/1/19 at $43.74 -AND-
200 Shares of Apple on 3/4/19 at $43.96
Then you sold:
300 shares of apple on 3/10/2020 at $71.34
Your 300-share sale would be composed of all 200 shares acquired on 3/1/19 and 100 shares of the 3/4/19 purchase.
Net gain calculation:
Sale Proceeds = 300 shares * $71.34 = $21,402
Less: Basis = 200 shares * 43.74 = $8,748
Less: Basis = 100 shares * 43.96 = $4,396
Net Gain = $8,258
Personal Use Assets
Gains on the sale of personal use assets are recognized as income and included in taxable gains. Losses on personal use assets are not deductible and cannot be used to offset gains or income.
Long term capital gains rates can offer significant savings over ordinary income rates. It is important to understand the concept so that asset sales can be planned for tax efficiency. For help with tax planning and preparation, please call us at 203-548-0220.
This site contains general information for taxpayers. Each situation depends on its unique facts. Do not rely on this content as a sole source of information. Seek professional advice before taking any action based on this information.