Capital Gains Tax? Yes, besides sales tax, excise tax, property tax, income tax, and payroll taxes, individuals who buy and sell personal and investment assets must also contend with the capital gains tax system. If you sell assets like vehicles, stocks, bonds, collectibles, jewelry, precious metals, or real estate at a gain, you’ll likely pay a capital gains tax on some of the proceeds.
Capital gains rates can be as high as 39.6%, and as low as 0%. Therefore, it’s worth exploring strategies to keep these taxes at a minimum.
Capital Gains Tax Basics
A capital gain occurs when the sales price you received for an asset is greater than your basis in that asset. The “basis” of an asset may be the price you paid for it. 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 schemes for capital gains:
- Short-Term Capital Gains are gains on assets you have held a year or less. Short-term capital gains are taxed at the same rates as ordinary income. 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 the tax rates for 2017 are between 10% and 39.6%.
- Long-Term Capital Gains are gains on assets you have held longer than one year. 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 your income. Gains on the sale of collectibles are taxed at 28%.
Exclusion for Sale of Primary Residence
Special rules apply to the capital gains when you sell your primary residence. If you meet the ownership and use tests, you can exclude up to $250,000 if you are unmarried, or $500,000 if you are married and filing a joint return. The tests mentioned are met if you own and use your house as your primary residence for two out of the five years immediately preceding the date of sale.
You can meet the ownership and use tests for different two-year periods, but both tests must be met within the five years immediately preceding the date of sale. This exclusion of capital gains is sometimes referred to as a Section 121 exclusion.
Reporting and Paying Capital Gains
Capital gains are reported on your annual tax return, along with income from other sources. Capital gains transactions are reported on Schedule D. Sales of securities are reported on Form 8949. Total capital gains or losses (limited to $3,000) are reported on Form 1040, line 13.
Unlike wages, there are no automatic federal or state taxes withheld from your capital gains proceeds. Therefore, 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 due at the end of the quarter during which you received the proceeds from the sale.
General Capital Gain Reduction Strategies
Regardless of what personal or investment assets you plan to sell, there are some strategies you can use to minimize the capital gains tax for which you are liable.
1. Wait Longer Than a Year Before You Sell
Capital gains qualify for long-term status when the asset is held longer than one year. If the gain qualifies for long-term status, then you qualify for the lower capital gains tax rate. Therefore, if you hold the asset longer than one year, your capital gains rate will be lower than your marginal rate.
- Marginal rates of 10% or 15% pay capital gains rate of 0%
- Marginal rates of 25%, 28%, 33%, or 35% pay capital gains rate of 15%
- Marginal rate of 39.6% pays capital gains rate of 20%
For example, if you are in the 33% tax bracket and sell stock that results in a $5,000 capital gain, here is the difference in tax if the gain is short- or long-term:
- Short-term (held a year or less before sold), taxed at 33%: $5,000 x .33 = $1,650
- Long-term (held longer than one year before sold), taxed at 15%: $5,000 x .15 = $750.
Holding the stock until it qualifies as long-term could lower your tax burden by more than half, depending on your marginal tax rate. The difference between short- and long-term can be as little as one day, so be patient.
2. Time Capital Losses With Capital Gains
In a given year, capital losses offset capital gains. 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 – a $10 gain.
Use your capital losses in the years that you have capital gains to reduce your capital gains tax. All of your capital gains must be reported, but you’re only allowed to take $3,000 of net capital losses each tax year. You do get to carry capital losses greater than $3,000 forward to future tax years, but it can take a while to use those up if a transaction generated a particularly large loss.
For example, suppose you sold a stock at a loss. If you have other stock that has appreciated in value, consider selling an amount of that stock, reporting the gain, and using the loss to offset the gain, thus reducing or eliminating your tax on that gain. Keep in mind, however, both transactions must occur during the same tax year.
For some of you, this strategy might sound familiar. It’s also referred to as tax-loss harvesting. It’s a popular feature with many robo-advisors including Betterment.
3. Sell When Your Income Is Low
As the list of rates above shows, your long-term capital gains rate is determined by your marginal tax rate, and your income determines your marginal tax rate. So, selling long-term capital gain assets in “lean” years may lower your capital gains rate and save you money.
If your income level is about to decrease – for example, if you or your spouse quit or lose a job, or if you’re about to retire – sell during a low-income year and minimize your capital gains tax rate.
4. Reduce Your Taxable Income
Since your capital gains rate is based on your income, general tax-saving strategies can help you qualify for a lower capital gains rate. Maximizing your deductions and credits before you file your tax return is a good strategy. For instance, donate cash or 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, contribute the full allowable amount to garner the largest deduction. Keep an eye out for obscure or little-known deductions, such as the moving expense deduction you can take if you move to take a new job. If you invest in bonds, consider municipal bonds, rather than corporate bonds. These municipal bonds’ interest is exempt from federal tax and thus is excluded from taxable income. There are a host of potential tax breaks. Using the IRS’s Credits & Deductions database might tip you off to deductions and credits you have been overlooking.
Capital Gains Savings When Selling Your Home
5. Limit the Rental Use of Your Home
Let us assume that you are not able to sell your home within your desired time frame, so you decide to rent it. Renting it may result in a paper loss you can claim to reduce your income at tax time. Such a loss is usually the result of allowed depreciation of the property. However, two things may temper your enthusiasm:
- Since you are renting your home, it is no longer your primary residence, so you are chipping away at the ownership and use tests that would allow you to exclude the capital gain when you sell. Consider renting for only two to three years, if you have lived in it for five years, in order to meet the tests to exclude capital gains when you sell. Remember that to get the exclusion, you must have lived in the home as your primary residence for two years within the five years immediately preceding the date of sale.
- Since you rented the home, you must recapture the depreciation. That recaptured depreciation can be taxed a couple of different ways. See IRS Publication 544, “Sales and Other Disposition of Assets,” for a (ponderous) discussion of whether the recaptured depreciation results in capital or ordinary gain.
In the final analysis, you might save more money by avoiding renting your home at all. You don’t have to contend with more complicated tax preparation (and possibly hiring a professional to do your taxes); you avoid a reduction in your basis due to depreciation; and you avoid the complexity of recaptured depreciation (with that recaptured depreciation, you may, when all is said and done, have lost money on the rental adventure).
6. Keep Records of Home Improvements
Additions or home improvements you make to your home over the years add to your basis in the property. A higher basis means, dollar for dollar, less capital gain when you sell. This tax savings benefits you in particular if your gain is greater than the exclusion amount for which you qualify, or if you do not meet the ownership and use tests.
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, remodeling, adding new flooring, and installing built-in appliances. Retain copies of receipts and records and keep a log of all the purchases you’ve made.
7. Track Selling Expenses
The sale price of the home can be reduced by any costs associated with selling the home, which will reduce the amount of capital gain resulting from the sale. If you have a taxable capital gain because you’ve exceeded your exclusion or the property doesn’t qualify, subtracting these expenses from the sale proceeds 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.
As an example, consider a couple who sell their home for $700,000. They pay a real estate broker 6% ($700,000 x .06 = $42,000). They pay an attorney $18,000 in fees, as well as closing, escrow, and recording. Their costs of sale are $60,000. Their net proceeds are, therefore, $700,000 – $60,000 = $640,000. Their basis in the home is $140,000. Their capital gain is $640,000 – $140,000 = $500,000. Since they meet the ownership and use tests and file jointly, they can exclude the entire capital gain. Had they not subtracted the costs of sale, they would owe capital gains tax on $60,000.
8. 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 wrote 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.
Avoid Capital Gains on Investments
There are multiple tax-saving strategies that work particularly well for investments like stocks, bonds, retirement funds, and rental properties.
9. 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 pretax 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 lower tax bracket when you retire.
However, you shouldn’t automatically assume that you’ll be in a lower bracket upon retirement. Although your income from employment may decrease when you retire, you may have additional income streams from Social Security, pensions, interest, and dividends. So, your marginal tax rate may be the same as before you retired. And, because you may have fewer potential deductions like student interest payments or mortgage interest payments, and you can’t claim your child as a deduction, your taxable income may actually rise.
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 or dividends are not taxed while in the account. Unlike 401ks and traditional IRAs, where contributions are from pretax dollars, contributions to Roth IRAs are from post-tax dollars, so distributions are not taxable.
Depending on your income, making contributions to a retirement account may generate a Saver’s Credit for you on your return.
10. 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 $14,000 per person (a couple filing jointly can gift up to $28,000), per year without incurring any gift tax. That means 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 $2,100. This so-called “Kiddie Tax” means that any tax benefits are usually reversed if the asset is sold.
11. 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 received in the exchange. 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 close on the purchase of 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 be able to 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. If there is money left over from the sale, not spent on the purchase, the intermediary gives it to you and it is taxable, usually as a capital gain.
You are not limited to one section 1031 exchange. Done properly, you can repeat the process and continue to defer the gain until you sell the last property you receive for cash.
12. 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. In fact, you can donate an appreciated asset and claim a tax deduction for its current fair market value.
For example, say you bought 100 shares of Apple at $63 and decided to donate it to charity. Your basis is $6,300. After its 7:1 split, let’s say the shares are worth $120. So, the value of your shares is 100 x 7 x $120 = $84,000. Your charitable deduction is $84,000, the fair market value on the date of donation of the stock. Moreover, you don’t have to pay capital gains tax on the $77,700 capital gain. Since charitable organizations are tax-exempt, the charity doesn’t have to pay capital gains taxes either.
Capital gains tax isn’t an issue that only affects the 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 engaging in a 1031 like-kind exchange), you’re better 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?