In addition to paying income tax and payroll tax, individuals who buy and sell personal and investment assets must also contend with the capital gains tax system. If you sell one of these assets – such as vehicles, stocks, bonds, collectibles, jewelry, precious metals, or real estate – and you sell it at a gain, you’ll pay a capital gain tax rate on some of the proceeds.
Capital gain rates can be just as high as regular income taxes. Therefore, it’s worth exploring every possible strategy to keep these taxes at a minimum.
Capital Gains Tax Basics
A capital gain is the difference between the sales price you received and your basis in the asset. The “basis” of an asset may be the price that you bought it for. However, if you’ve made improvements to the asset, the cost of the improvements increases your basis. If you’ve depreciated the asset, that decreases your basis.
Capital Gain Tax Rates
There are two different tax rates for capital gains.
- Short-Term Capital Gains. Short-term capital gains are taxed at ordinary income tax rates. This is the same rate that you pay on work wages, freelancing income, or interest income. The tax rate you must pay varies based on your total taxable income, but you can expect to pay somewhere between 10% and 39.6% as of 2015.
- Long-Term Capital Gains. Long-term capital gains are taxed at more favorable rates. Current tax rates for long-term capital gains can be as low as 0% and top out at 20%, depending on income. Capital gains are considered to be long-term if the owner holds the asset for at least a year.
Exclusion for Sale of Primary Residence
There are some special rules around capital gains and home sales. If you’re selling a house that has been your primary residence for at least two of the past five years, take full advantage of the IRS capital gain exclusion. The IRS offers an incredibly generous capital gain exclusion to taxpayers who sell their primary residence: A single taxpayer can exclude $250,000 worth of the gain on the sale of a home, and a couple can exclude $500,000.
Reporting and Paying Capital Gains
Capital gains are reported on your annual tax return along with income from other sources. Unlike wages, there are no automatic federal or state taxes withheld from your capital gains proceeds. That means if you have significant capital gains, you may need to make estimated tax payments to the IRS throughout the year.
Complete the worksheet on Form 1040-ES to check whether you need to make estimated tax payments to the IRS. Estimated tax payments are usually first due at the end of the quarter that you received the proceeds from the sale.
General Capital Gain Reduction Strategies
Regardless of what personal or investment asset you’re selling, there are some basic rules you should always follow to minimize your capital gains taxes.
1. Wait at Least a Year Before You Sell
So that capital gains qualify for long-term status (and a lower tax rate), wait until you’ve held the asset for at least one calendar year before you sell it. Depending on your tax rate, you could save 10% to 20%.
For example, if you sell stock that results in a capital gain of $2,000, are in the 28% income tax bracket, and you’ve held the stock for more than a year, you’ll pay 15% of $2,000, or $300 on the transaction. If you’ve held the stock for less than a year, you’ll pay 28% of $2,000, or $560 in taxes on the transaction.
2. Sell When Your Income is Low
Your income level impacts the amount of long-term capital gains tax you pay. Taxpayers in the 25%, 28%, 33%, and 35% ordinary tax brackets pay 15% on longer-term capital gains. Taxpayers in the 39.6% bracket pay 20%.
However, taxpayers in the 10% and 15% brackets pay no long-term capital gains tax at all. If your income level is about to decrease – for example, if your spouse is quitting her job soon to take care of family or if you’re about to retire – sell during a low income year and minimize your capital gains tax rate.
3. Reduce Your Taxable Income
Since your capital gain tax rate is based on your taxable income, general tax-savings strategies can help you snag a rate. Make every effort to maximize your deductions and credits before you file your tax return. For instance, donate goods to charity and take care of expensive medical procedures before the year’s end.
If you contribute to a traditional IRA or a 401k, maximize your contributions to get the biggest deduction. Keep an eye out for obscure or little-known deductions, such as the moving expense deduction you can take if you move for your job. Consider purchasing bonds issued by states, local governments, and municipalities, rather than corporate bonds. These municipal bonds produce income exempt from federal tax and are excluded from taxable income. There’s a plethora of potential tax breaks, so use the IRS’s Credits & Deductions database to learn what you might qualify for.
4. Time Capital Losses With Capital Gains
One notable feature of capital gains is that they’re reduced by any capital losses that you incur that year. For example, if you earned a $50 capital gain selling Stock A, but sold Stock B at a $40 loss, your net capital gain is the difference between the gain and loss, or $10.
To reduce your tax, use up your capital losses in the years that you have capital gains. There’s no limit on the amount of capital gains you must report, but you’re only allowed to take $3,000 of net capital losses each tax year. You do get to carry additional capital losses forward into future tax years, but it can take a while to use those up if you’ve absorbed a particularly large loss.
For example, say you sold a stock at a loss, or for less than you paid. If you have other stock that has appreciated in value, consider selling an amount of that stock, thereby capturing the gain, and using the aforementioned loss to offset the gain and negate or reduce capital gains taxes. Both transactions must occur during the same tax year.
Capital Gains Savings When Selling Your Home
1. Limit the Rental Use of Your Home
If you choose to rent out your old house instead of selling it, you’re in danger of losing the exclusion. To qualify for the exclusion, you must have lived in the home for two of the five years prior to the home sale. That means that the exclusion starts to phase out once you start to rent your house for three years, and you can potentially lose the exclusion completely. To avoid this situation and minimize your taxes, sell your ome within three years of moving out or converting it to a rental.
2. Keep Records of Home Improvements
Keep thorough records of any home improvements or additions you’ve made to your home over the years. In addition to increasing your home’s value, any improvements that you make to your home increase your basis in the home and thereby reduce your capital gain dollar for dollar. This tax-savings strategy can be particularly valuable if you have a gain because the property doesn’t qualify for the primary residence exclusion, or you’ve exceeded your exclusion amount.
According to the IRS, an improvement is anything that betters your home, adapts it, or restores your home to a previous condition. Adding rooms, a deck, a pool, a retaining wall, or landscaping the property all count as improvements. Upgrading windows and doors, plumbing, insulation, heating, cooling, or sprinkler systems also qualify, as does restoring damaged parts of your home, remodels, new flooring, and built-in appliances. Retain copies of receipts and records and keep a log of all the purchases you’ve made.
3. Track Selling Expenses
Capital gains are reduced by any expenses that you incur to sell the home. If you have a taxable capital gain because you’ve exceeded your exclusion or the property doesn’t qualify, reporting these expenses will reduce your capital gain amount.
While you can’t deduct cleaning or maintenance expenses from your reported selling price, there are many other selling costs that qualify. Nolo notes that settlement fees, broker commissions, escrow and closing costs, advertising and appraisal fees, points paid by the seller, title search fees, transfer taxes, and any miscellaneous document preparation fees can all reduce your capital gain. As with home improvements, keep records and receipts in case the IRS wants to see them.
4. Move Often
The IRS capital gain exclusion is large enough that many taxpayers will never have to pay taxes on the sale of their homes. However, if you’ve held your property for a long time, bought in a hot area, or are single, the exclusion may not completely cover your gain.
To use the capital gain exclusion to its fullest potential, tax expert David John Marotta writes in Forbes that you should consider a move when you’ve maxed out the capital gain exclusion on your home. Although you need to have lived in your house for at least two years to claim the exclusion, the IRS allows taxpayers to use the exclusion multiple times (no more than once every two years in general). This means you could potentially sell multiple homes at a large gain and never pay a dime in taxes.
Avoiding Capital Gains on Investments
There are multiple tax avoidance strategies that work particularly well for investments such as stocks, bonds, retirement funds, and rental properties.
1. Use a Retirement Account
You can use retirement savings vehicles such as 401ks, traditional IRAs, and Roth IRAs to avoid capital gains and defer income tax. With 401ks and traditional IRAs, you can invest in the market using pre-tax dollars. You’ll never pay capital gains on the earnings, although you will pay ordinary income tax when you withdraw the income. Investing this way can save you a bundle on taxes if you’re in a low-income tax bracket when you retire.
However, you shouldn’t automatically assume that you’ll be in a lower bracket upon retirement. Although your income may decrease upon retirement, so do your potential deductions. If you won’t have deductions like student interest payments and mortgage interest payments, and you can’t claim your child as a deduction, your retirement tax bracket could potentially be the same as your pre-retirement tax bracket.
If you’re not sure whether you’ll be in a lower tax bracket at retirement, a Roth IRA is another way to avoid capital gain taxes. Like 401ks and traditional IRAs, gains aren’t taxed while in the account. Unlike 401ks and traditional IRAs, taxpayers can only contribute post-tax earnings to a Roth IRA account. However, the withdrawals are tax-free.
2. Gift Assets to a Family Member
If you don’t want to pay 15% or 20% in capital gains taxes, give the appreciated assets to someone who doesn’t have to pay as high a rate. The IRS allows taxpayers to gift up to $13,000 per person, per year without incurring any gift tax. That means that you could gift appreciated stock or other investments to a family member in a lower income tax bracket. If the family member chooses to sell the asset, it will be taxed at his or her rate, not yours. If he or she is in the 10% or 15% ordinary income tax brackets the year of the sale, capital gains tax could be avoided entirely.
This is a great way to pass on financial support or gifts to family members while minimizing capital gains tax. Note, however, that the tactic doesn’t work well for gifting to children or students under the age of 24. These dependents have to pay at their parents’ tax rates if they have unearned income from any sources – such as capital gains or interest income – that exceeds $2,000. This so-called “Kiddie Tax” means that any tax benefits are usually reversed if the asset is sold.
3. Exchange Rather Than Sell
Exchanging assets is another legitimate tax trick to defer capital gain taxes. Exchanging like-kind assets allows you to defer the gain until you finally sell the asset you exchanged for. The IRS allows like-kind exchanges – referred to as 1031 exchanges- for real estate and other investment assets.
A like-kind exchange occurs when you sell one asset and buy another asset of the same type within 180 days. You don’t necessarily have to swap assets with one person to qualify for the exchange and defer the gain. However, proceeds from the asset you sell must go through a qualified intermediary, and the proceeds must be used to purchase the new asset.
4. Donate to Charity
If you donate your appreciated asset to a charity or nonprofit that you support, you’ll get a nice tax deduction along with no capital gains taxes. According to tax law expert William Baldwin, you can donate an appreciated asset and claim a tax deduction for its current fair market value.
For example, say that you bought stock for $1,000 and it’s currently worth $6,000. If you donate that stock to your favorite charity, you can claim a charitable contribution of $6,000 on your taxes. What’s more, you don’t have to pay capital gain taxes at all, even though the stock appreciated by $5,000. Since charitable organizations are tax-exempt, the charity doesn’t have to pay capital gains taxes either.
Capital gains tax isn’t just an issue that affects the very wealthy. Ordinary taxpayers can easily save thousands of dollars on capital gains taxes by using a few of these strategies. Just remember that for some of the more complicated tax strategies (such as enacting a 1031 like-kind exchange), you’re best off consulting with a tax accountant to make sure you get all the details right.
Can you suggest any additional strategies to avoid capital gains taxes?