5 Things to Know About Capital Gains Tax
It can be hard to think about taxes outside of January – April, but a better understanding of capital gains tax will put you in a better place come next tax season when trying to estimate what you might owe the IRS. Keeping your budget in balance is something to think about all year round, after all!
What is a capital gain?
It’s pretty simple: a capital gain happens whenever you sell something for more than you spent to buy it. This goes for investments as well as personal property. If you purchase, say, an antique piece of furniture for $100 at an estate sale and then turn around and sell it for $3,000 a month later, you have a $2,900 capital gain. The same equation applies if it were any other capital asset (which are most things you own) or stock.
Capital gains and capital assets may sound fancy, but “capital” here refers to things with significant financial value. Regardless of how you use the capital asset—property or stocks bought as investments, or a camper or big-screen TV for personal use—if you sell it for more than your “basis” in the item (what it cost you to acquire it), then the difference is considered a capital gain—a gain of financial value. Your basis includes all of the costs it took to acquire the item: sales taxes, excise taxes, any other taxes and fees, shipping and handling costs, and installation and setup charges.
It follows that any money you spend on improving the capital asset and increasing its value—restoring a vintage car, refinishing an antique farm table, improving a building—is added to your basis. Likewise, depreciation of an asset reduces your basis.
Your home is exempt. Usually.
Most people’s largest capital asset is their home. So, the idea of having to pay more taxes if they receive a capital gain on the sale might give them a little heart burn! But don’t panic just yet. The tax code allows you to exclude part or all of this type of gain from capital gains tax as long as you meet the following three conditions:
- You owned the home for at least two years in the five-year period before you sold it.
- The home was your primary residence for at least two years during that same five-year period.
- You haven't excluded the gain from another home sale in the two-year period before the current home sale.
If these conditions apply to you, then you’re allowed to exclude up to $250,000 of your gain from the sale of the house if you're single, up to $500,000 if you're married and filing jointly.
Length of ownership matters.
There are two classes of capital gain: long term and short term. If you sell a capital asset after only owning it for a year or less, it’s a short-term capital gain; if you owned it for more than a year before selling, it’s a long-term capital gain. This is important because the tax you pay for short-term capital gains is quite a bit larger than for long-term gains.
But how much is “quite a bit larger?” It’s often 10 to 20 percent more, sometimes higher. This difference in tax treatment is what leads many to follow the "buy-and-hold" strategy when planning to sell capital assets.
Those in the lowest tax brackets usually don't have to pay any tax on long-term capital gains. For them, the difference between short and long term can literally be the difference between paying and not paying this particular tax.
Capital losses can offset gains.
What goes up, can also come down. If you sell a capital asset for less than its total basis, you’ve experienced a capital loss. While capital gains from the sale of investments (i.e., stocks, etc.) and personal property are treated similarly, capital losses for the two are a different matter.
Capital losses from investments can be used to offset capital gains from other investments. For example, if you have $60,000 in long-term gains from the sale of Stock A but $20,000 in long-term losses from the sale of Stock B, then you may only be taxed on $40,000 of long-term capital gains.
In addition, if capital losses exceed capital gains in your investments, you can usually use the loss to offset up to $3,000 of other income. If you have more than $3,000 in capital losses, the amount over $3,000 can be carried forward to future years to offset capital gains or income of those years.
Business income isn’t a capital gain.
The rules of capital gains, and its tax, change if you operate a business. When you buy and sell items as a business for a profit, that income is taxed as business income and not as capital gains. Likewise, the money a business (even a single-person business) pays for items is a business expense, which means the money received for selling items is business revenue, and this difference between the two amounts is classified as business income, which is subject to employment taxes.