Since you only pay tax on the profit you make, it’s necessary to keep good records from the time you acquire an asset through the sale process. A few different factors, including how long you held the asset and your marginal tax bracket, influence 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 taxes on stock gains. 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.
Each is taxed at a different rate. 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 the following documentation:
- The exact date you purchased the item
- Records of the purchase price, including any taxes and fees you paid
- Records of the exact date that you sold the item
- How much it sold for and fees you paid while holding it (although in the case of real estate, this doesn’t include amounts 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 top-tier rate as your regular income. On the other hand, long-term capital gains on most items are taxed at either 0% (for 10% and 15% tax brackets), 15% (for 25% through 35% tax brackets), or 20% (for the 39.6% tax bracket) in 2015. That said, certain other items may be taxed differently – for instance, collectibles are taxed at a maximum rate of 28%.
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 for longer than one year.
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 and lived in it 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. See IRS Publication 523 for further detail and special circumstances.
- 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 subtract some closing costs (including legal, title, and recording fees) the cost of additions or substantial home improvements (but not repairs), and the real estate commission 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, in most cases 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. Plus, while you own it, you get to deduct the expenses of maintaining it as well as depreciation against the rental income.
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.
A capital loss can reduce your taxes. If your capital losses exceed capital gains, you can deduct the loss from your income, up to $3,000 (unless you’re married filing separately, in which case, you can deduct up to $1,500).
For instance, say you have one stock that you sold, 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.
Capital Loss Carryover
In addition to the ability to deduct up to $3,000 in capital loss per year ($1,500 if you file as married filing separately) against your income, you can carry over the excess to deduct in a future tax year. In other words, 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.
Keep in mind that 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 Sale
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 purchase 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?