What is Capital Gains Tax?

When you sell stocks or real estate, you hope to make some money on the deal, right?  Well, when you do, the IRS will come calling for their share – known as the capital gains tax.  Understanding what it is and how it is calculated, is the first step to understanding how to lower the amount of capital gains taxes you owe.

When is the capital gains tax assessed?

A “capital gain” occurs when the sale price of an asset is higher than the initial purchase price.  In other words, when you make a profit from selling some property, you just received a capital gain.  For instance, if you bought a diamond ring for your wife for $3,500, and later sell it for $4,500, the capital gain is $1,000.  You will then be taxed a certain percentage of your “realized” capital gains. A capital gain is not “realized” until the asset is actually sold. If your assets have simply increased in value, but you have not yet sold that asset, then it would only be an unrealized capital gain.

For example, let’s say you buy some stock in Google, and over the course of a year the stock goes up by $100. If you hold onto the stock, the IRS can’t tax you for that $100. But if you sell the stock and collect your $100 profit, then that’s a realized capital gain and is therefore taxable.

Which kinds of assets are taxable?

A capital asset, as defined by the IRS, is “almost everything you own and use for personal or investment purposes.” The most common taxable assets are securities, real estate and valuable collectibles.  Securities are financial instruments or investment contracts that have value, such as stocks and bonds.

If you sell real estate or other property, either for personal or business purposes, and profit from the sale, that qualifies as a capital gain. Different tax rates apply to the sale, depending on whether it was personal or business property.  With regards to your primary residence, taxpayers are allowed to exclude up to $250,000 in capital gains from the sale of that particular property if you are filing single, and $500,000 if you are married and filing jointly.  Your primary residence can include trailers and houseboats.

How can I Lower My Capital Gains Tax

The easiest way to lower the amount you will owe in capital gains taxes, is to avoid any short-term investments.  That is because long-term investments nearly always have lower tax rates than short-term investments.  So, if you fall in the lowest tax brackets, you will likely pay no taxes on long-term capital gains.  It might seem like a better idea to make a short-term investment with a higher interest rate.  However, after capital gains tax is collected, that long-term investment might leave you with more profit.

Another method for lowering your capital gains tax is to shelter as much of your income as possible in tax-deferred retirement accounts, such as 401(k)s, Roth IRAs and Traditional IRAs.  The benefit to these retirement accounts is that you can buy, sell and exchange securities within the account itself without being charged any capital gains tax. These accounts shelter your investments from capital gains tax as long as any money earned from the sale is reinvested in another security.

If you have questions regarding capital gains tax, or any other retirement planning issues, please contact Wilcox Attorneys, PA online, or by calling us at (479) 443-0062.