Since you only pay taxes on the profit you make, it’s necessary to keep good records from the time you acquire them through the sale process. Depending on when you acquired the assets and when you sell them, you could substantially alter how much you’ll pay.
Below are the definitions and general tax rules for capital gains and losses.
What Are Capital Gains and Losses?
In order to fully understand what you’re dealing with, you need to first be familiar with some basic terminology. Here are a few terms you need to know:
- Capital Asset. Generally, the term refers to stocks, bonds, real estate, or other assets that have a value. The IRS defines pretty much everything you own as an asset, including your home, vehicles, and possessions. (If you have a business, this excludes anything that is used for your business or belongs to your business.)
- Capital Gains. A capital gain is profit that you receive after selling a capital asset, minus its original cost. During the time that you own a capital asset, such as a share of stock, you don’t pay income taxes on its value. When you sell the share of stock, however, you may have to pay tax on your profit. In order to determine your profit, you’ll generally take the amount you paid for the share, plus any fees you paid, and subtract that from the amount you sold it for.
- Capital Loss. This occurs when you sell a capital asset but don’t recoup the amount you paid (i.e. you took a loss on it).
- Cost Basis. Simply put, this is the amount you paid for an asset, including any fees or taxes.
Now that you know how to define your investments, take a look at how the IRS handles them.
How Are Capital Gains Taxed?
The amount of taxes that you pay on a capital gain depends on the income tax bracket you’re in, how long you have owned the asset, and the type of capital asset you’re dealing with. Consider the following when reviewing your capital gains:
1. Length of Ownership
There are two separate designations for the length of time you own a capital asset:
- Short-term: This refers to an asset you have owned for one year (365 days) or less.
- Long-term: Any capital asset you have owned for longer than one year (more than 365 days) is considered long-term by the IRS.
Since each of these is taxed at a different rate, it is extremely important to know where your capital assets fall. To determine whether your gain will be taxed at a short-term or long-term rate, and to figure out the cost basis of the asset, you will need to have clear documentation of:
- The exact date you purchased the item
- Records of the purchase price, including any taxes and fees you may have paid
- Records of the exact date that you sold the item
- How much it sold for – although in the case of real estate, this doesn’t include amounts you paid to maintain it
Once you have all of the proper documentation in hand, you can find the exact amount that you should declare as a gain or profit, and begin the process of determining the tax rate.
Short-term capital gains are taxed at the same rate as your regular income, and therefore that rate will depend on how much total income you have. On the other hand, long-term capital gains are taxed at either 0%, 15%, or 20% (for tax year 2014) depending on your tax bracket.
Since it is more than likely that the long-term rate is lower than your tax bracket, it can be very advantageous to hold assets a little longer. If you can wait until after you’ve owned them at least a year to sell, you’ll qualify for the lower tax rate. Use this capital gains calculator on Smart Money to show you how much you can save by waiting.
Any long-term capital gains from the sale of collectibles (that you owned for personal reasons and not as an investment) is capped at 28% no matter what your personal tax bracket is. The same cap is placed on the sale of section 1202 qualified small business stock. And finally, the portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.
2. Capital Gains on Selling Your Home
The IRS does consider money you make off selling your primary residence to be a capital gain. Luckily, they give you a lot of breaks on what can be a substantial profit. Here are the two most significant ones:
- No Tax on the First $250,000. This is a big one. You don’t have to pay capital gains taxes on the first $250,000 you make on the sale of your home ($500,000 if you file as married filing jointly) as long as you’ve owned the home at least two years, lived there as your main home at least two years of the previous five, and didn’t take this break for any other home sale in the past two years. Click here for more specific rules.
- Additional Expenses Are Included. The second break is that the cost basis of your home (for most assets, the amount you paid for it) has several common expenses added to it. You can often subtract points you paid on your original mortgage, closing costs, real estate taxes paid in the year you bought the home, the cost of additions or substantial home improvements (but not repairs), and real estate fees paid to your agent to sell the home. Raising the cost basis allows you to have a smaller gain, and in turn, pay less in capital gains taxes.
Unfortunately, if you have a loss on your home, you can’t claim it on your taxes.
3. Capital Gains on Selling an Investment Property
The rules for capital gains tax on the sale of an investment property differ from those governing the sale of your home. For example, you don’t get the nice $250,000 break, but you do get to deduct most of the expenses of buying, improving, or selling the home as listed above; plus, while you own it, you get to deduct the expenses of maintaining it as well as depreciation.
When you sell the investment property, however, that depreciation gets “recaptured” which could result in a larger capital gain (get a tax professional to help you here). However, unlike your primary residence, a loss on an investment property can be claimed as a capital loss on your taxes.
While capital gains are always potentially taxable, a capital loss can actually reduce your taxes in some situations. If you have certain kinds of capital losses but had no capital gains that year, you can deduct the loss from your income on your taxes.
Even if you have a combination of gains and losses, it can reduce your taxes. Capital losses are subtracted from capital gains, reducing the total amount that is taxed.
For instance, say you have one stock that you sold after it did very well, and you made $1,000 in capital gains. You also have another stock that went down in value by $1,000 and you don’t think it’s going to come back up. You can cut your losses and sell the badly performing stock. In this case, you would have a zero net gain or loss.
Deduction Capital Losses
Fortunately, there is a stipulation for tough times. You can deduct up to $3,000 worth of losses per year ($1,500 if you file as married filing separately) and subtract it right off the top of the income you made. That means up to $3,000 of your income will be tax-free that year. If you had more than $3,000 in capital losses after all your gains were accounted for, you can actually roll the rest of it (up to another $3,000) into next year’s tax return and deduct it there.
Though there are ways to use them to your advantage, the guidelines for claiming capital losses are fairly restrictive. The rule of thumb is: Only assets you bought strictly for investment purposes can generate a capital loss. Thus, if you sell any personal assets like your home or vehicle for a loss, you can’t claim it.
Beware the Wash Sales
If you’re a follower of the stock market, you might notice quite a bit of activity in the last few weeks of the year, as people dump under-performing stocks in order to take capital losses and get a tax break. This may sound like a good idea, but you need to make sure that you really want to dump that stock, because if you buy it back too quickly, you can lose your capital loss deduction.
This is called the wash sale rule. If you sell stock for a loss, you can’t make any other purchases of that stock for 30 days before or after the date you sold it. This is intended to keep people from dumping stock on December 31st to get their capital loss recorded on that year’s taxes, and then snapping the stock back up on January 1st. If you violate this rule, you can’t take the loss on this year’s taxes. For a more in-depth explanation of the wash sale rule, see IRS Publication 550.
While it takes an eye for the market to make a mint on stocks or real estate, it doesn’t take much more than decent planning to ensure you’ll get good tax rates when you sell your appreciated assets. If you have a lot of assets in the stock, bond, or real estate market, consider working with a knowledgeable accountant on a quarterly basis to manage your tax exposure.
Have you ever sold an item to take the capital loss deduction? How do you manage your taxes for gains and losses when investing?