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 capital 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 37%, 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 cost 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 2021 are between 10% and 37%.
- 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 7. If you use tax preparation software like H&R Block, you’ll be able to easily enter your capital gain numbers for calculation in your tax liability.
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 due on April 15, June 15, September 15, and January 15 of the following tax year. If that date falls on a weekend or holiday, the due date shifts to the next business day.
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. 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.
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, that both transactions must occur during the same tax year.
This strategy might sound familiar. It’s also referred to as tax-loss harvesting. It’s a popular feature with many robo-advisors, such as Betterment and Wealthfront.
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.
2. 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.
Long-term capital gains tax rates depend on your filing status and your total long-term gains for the year. For 2021, the long-term capital gains tax brackets are as follows:
|Tax Rate||Single, Taxable Income Over||Married Filing Jointly, Taxable Income Over||Head of Household, Taxable Income Over|
In addition to the rates above, high-income taxpayers may also have to pay the Net Investment Income Tax (NIIT) on capital gains. NIIT applies an additional 3.8% tax on all investment income, including capital gains. NIIT applies if your income is above $200,000 for single and head of household taxpayers and $250,000 for married couples filing a joint return.
As you can see, the difference between a long-term sale and a short-term sale can be significant. To illustrate, say you are a single person with a total taxable income of $39,000. You 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 12%: $5,000 x 0.12 = $600
- Long-Term (Held Longer Than One Year Before Sold), Taxed at 0%: $5,000 x 0.00 = $0.
Holding the stock until it qualifies as long-term would save you $600. The difference between short- and long-term can be as little as one day, so be patient.
3. Sell When Your Income Is Low
If you have short-term losses, your marginal tax rate determines the rate you’ll pay on capital gains. So, selling 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 short-term 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 401(k), contribute the full allowable amount to garner the largest deduction. Keep an eye out for obscure or little-known deductions that can lower your tax bill. If you invest in bonds, consider municipal bonds, rather than corporate bonds. Municipal bond 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’ve overlooked in the past.
5. Do a 1031 Exchange
A 1031 exchange refers to section 1031 of the Internal Revenue Code. It allows you to sell an investment property and put off paying taxes on the gain, as long as you reinvest the proceeds into another “like-kind” property within 180 days.
The definition of like-kind property is pretty broad. For example, if you own an apartment building, you might exchange it for a single-family rental property or even a strip mall. You can’t exchange it for stock, a patent, business equipment, or a home you plan on living in.
The key with 1031 exchanges is that you defer paying tax on the property’s appreciation, but you don’t get to avoid it entirely. When you sell the new property later on, you’ll have to pay taxes on the gain you avoided by doing a 1031 exchange.
The rules for executing a 1031 exchange are complicated. If you’re thinking of doing one, talk to your accountant or CPA or work with a company that facilitates 1031 exchanges. This isn’t a strategy you can DIY.
Capital Gains Savings When Selling Your Home
6. Limit the Rental Use of Your Home
Let us assume that you aren’t 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.
First, since you’re 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.
Second, 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, you avoid a reduction in your basis due to depreciation, and you avoid the complexity of recaptured depreciation. With that recaptured depreciation, you may have lost money on the rental adventure when all is said and done.
7. 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 that increases basis is anything that adds to the value of your home, prolongs its useful life, or adapts it to new uses.
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.
8. 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. IRS Publication 523 notes that settlement fees, abstract fees, charges for installing utility service, legal fees, recording fees, survey fees, transfer or stamp taxes, and owner’s title insurance 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.
9. 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 you to use the exclusion multiple times during your lifetime. 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.
10. Use a Retirement Account
You can use retirement savings vehicles, such as 401(k)s, traditional IRAs, and Roth IRAs, to avoid capital gains and defer income tax. With 401(k)s 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 401(k)s and traditional IRAs, gains or dividends are not taxed while in the account. Unlike 401(k)s 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.
11. 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 $16,000 per person (a couple filing jointly can gift up to $32,000), per year without needing to file a gift tax return.
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 their rate, not yours. In some cases, 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 the same tax rates as their parents if they have unearned income from any sources – such as capital gains or interest income – that exceeds $2,200. This so-called “Kiddie Tax” means that any tax benefits are usually reversed if the asset is sold.
12. Donate to Charity
If you donate your appreciated asset to a charity or nonprofit 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-to-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 tax-loss harvesting or gifting appreciated stock, you’re better off consulting with a tax accountant to make sure you get all the details right.