When you sell an investment, you pay tax only on the profit you make, rather than the full proceeds from the sale. For that reason, you must keep good records from the time you acquire the asset through the sales process. A few different factors, including how long you held the asset and your marginal tax bracket, influence how much you’ll pay.
Here’s what you need to know about tax rules for capital gains and losses.
What Are Capital Gains & Losses?
To fully understand how capital gains and losses impact your taxes, you need to be familiar with some basic terminology. Here are a few definitions you should know:
- Capital Asset. Generally, the term capital asset refers to stocks, bonds, real estate, or other assets that have value. The IRS considers pretty much everything you own as a capital asset, including your home, vehicles, and possessions. If you have a business, capital assets do not include anything that’s used for your business, such as inventory.
- Capital Gain. A capital gain is a profit you receive after selling a capital asset, minus its original cost. During the time you own a capital asset, such as a share of stock, you don’t pay taxes as the stock increases in value. However, when you sell the stock, if you sell it for more than you paid for the share, you pay taxes on the difference between the selling price and what you paid for the share, plus any fees you paid.
- Capital Loss. A capital loss occurs when you sell a capital asset for less than what you paid for the asset.
- Cost Basis. Your cost basis in a capital asset is the amount you paid for the asset, including any fees or taxes.
Now that you know how to define your investments, let’s take a look at how the IRS handles them.
How Are Capital Gains Taxed?
The amount of taxes you pay on capital gains depends on how much you made from the sale, how long you’ve owned the asset, and the type of capital asset you’re dealing with. Consider the following when reviewing your capital gains:
Long-Term vs. Short-Term Holding Period
There are two holding periods that matter when calculating your tax bill on a capital gain or loss:
- Short-Term. Short-term capital gains or losses refer to assets you’ve owned for one year (365 days) or less.
- Long-Term. Long-term capital gains and losses come from capital assets you’ve owned for longer than one year (365 days).
Short-term capital gains and long-term capital gains are taxed at different rates. 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 need to have documents showing the following:
- The exact date you purchased the asset
- The purchase price, including any taxes or fees you paid (you must also track additional investments made to increase the value of the asset, such as improvements made to real estate or dividends reinvested)
- The exact date you sold the item
- The sales price you received for the asset and any fees or other costs of selling it
Once you have all of the proper documentation, you can calculate the exact amount you should declare as a capital gain or loss and determine the applicable tax rate.
Capital Gains Tax Rates
Short-term capital gains are taxed at the same rate as your ordinary income, such as wages from a job. Long-term capital gains, on the other hand, are taxed at special long-term capital gains rates.
Before the Tax Cuts and Jobs Act of 2017 (TCJA), those rates were tied to your ordinary income tax brackets. If your long-term capital gains fell within the 10% or 15% income tax bracket, your tax rate on those gains was 0%. If they fell into the 25% to 35% tax brackets, your tax rate on those gains was 15%. And if they fell within the maximum 39.6% tax bracket, you paid the maximum 20% rate.
The TCJA retained the 0%, 15% and 20% rates on long-term capital gains, but they’re no longer tied to ordinary income tax brackets. For the 2018 to 2025 tax years, long-term capital gains have their own tax brackets. For 2020, they are:
|Tax Bracket||Single||Joint||Head of Household|
|0%||$0 – $40,000||$0 – $80,000||$0 – $53,600|
|15%||$40,001 – $441,450||$80,001 – $496,600||$53,601 – $469,050|
|20%||$441,451 & up||$496,601 & up||$469,051 & up|
For most people, their long-term capital gains tax rate is lower than their ordinary income tax bracket, so it’s advantageous to hold assets for longer than one year.
Not every capital asset is taxed the same way. The IRS has special rules for taxing gains when selling your home or collectibles, such as art and antiques.
Capital Gains on Selling Your Home
The money you make selling your primary residence is considered a capital gain. Fortunately, the tax code gives you a couple of breaks that can make a substantial amount of your profit tax-free.
- No Tax on the First $250,000 of Gain. 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, or $500,000 for the married filing jointly status. To qualify for this break, you must have owned the home and lived in it as your primary residence for two out of the last five years before the sale, and you cannot have used this exclusion on another home in the past two years. See Publication 523 for more details and special circumstances.
- Closing Costs and Improvements Increase Basis. The cost basis of your home includes many of your closing costs, including legal, title, and recording fees and commissions. It also includes the cost of any additional or substantial home improvements (but not repairs). Keeping track of these expenses may help you avoid a large taxable gain.
To illustrate, let’s say you purchased a home in 2009 for $150,000 and paid $4,000 in closing costs. You lived in the home as your primary residence and put $100,000 of improvements into the home during that time. In 2020, you sell the home for $525,000. Your taxable gain would be as follows:
|Less Basis ($150,000 + $4,000 + $100,000)||– $254,000|
|Less Exclusion||– $250,000|
By keeping adequate records of the original purchase price of the home, the closing costs you paid, and the improvements you put into the home, you avoid being taxed on a significant amount of the profit you make when selling the property.
Capital Gains on Collectibles
If you invest in collectibles such as art, stamps, coins, antiques, and other items that tend to appreciate over time, you need to know about the tax treatment of gains on collectibles.
Gains on collectibles owned for one year or less are taxed at ordinary income rates, the same as sales of stocks or other capital assets. But gains on collectibles held for more than a year are taxed at a 28% capital gains tax rate, regardless of the amount of gain.
How Do Capital Losses Affect Taxes?
When you sell capital assets at a loss, you can use the loss to offset other capital gains. If your capital losses exceed your capital gains, they can offset up to $3,000 of other income – unless you’re married and file a tax return separately from your spouse, in which case you can deduct up to $1,500.
For example, say you sold Stock A and made $5,000 in capital gains. You also sold Stock B at a $7,000 loss. You can use $5,000 of those long-term losses to offset the gain you made on Stock A, and the additional $2,000 of capital losses can be used to offset your ordinary income, such as wages.
Capital Loss Carryover
What if, in the scenario above, your loss on Stock B was $9,000 instead of $7,000? In that case, you could use $5,000 of that loss to offset the gain made on the sale of Stock A, use $3,000 to offset other income, and you’d still have $1,000 of capital loss left over. Don’t worry; that excess loss won’t go away, even though you can’t use it this year. You’ll have a capital loss carryover you can use in a future tax year.
Keep in mind that the guidelines for claiming capital losses are fairly restrictive. The rule of thumb is that only assets you bought for investment purposes can generate a capital loss. Thus, if you sell your home, vehicle, furniture, or even collectibles that you used personally at a loss, you can’t claim it.
Beware of the Wash Sale Rule
Stock market followers notice quite a bit of activity in the last weeks of the year as taxpayers dump underperforming stocks to take capital losses and get a tax break. This can be a tax-saving strategy, but you need to make sure 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, and it’s designed to prevent investors from unloading stocks at the end of the year, claiming capital losses, and then repurchasing the stocks right away. Wash sale rules state that if you sell a stock at a loss, and you buy a “substantially identical” stock or security within 30 days before or after the sale, the capital loss is not deductible.
For a more in-depth explanation of the wash sale rule, see IRS Publication 550.
It takes either dumb luck or an eye for the market to win big investing in stocks or real estate, but it only takes decent planning to take advantage of tax-advantaged rates when you sell appreciated assets. If you have a big portfolio of stocks, bonds, and real estate holdings, you should work with a knowledgeable financial advisor and tax professional from H&R Block to manage your tax exposure.