Capital Gains and How Are They Taxed

The Basics of Capital Gains

Capital gains (and capital losses) are the gains or losses made when selling an investment, and are taxed differently depending on the type of asset, the length of time the asset was held, as well as where you live.
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The term capital gain, or capital gains, is used to describe the profit earned from buying something at one price and selling it at a different, higher price. For instance, if you bought a piece of real estate for $500,000 and sold it for $800,000, you would need to report total capital gains of $300,000.

Capital gains is a term often used in the context of investing. But the discussion isn't limited to stocks, bonds, or mutual funds. Capital gains can also apply to works of art, real estate, vehicles, baseball cards, bottles of wine, silver coins, rare postage stamps, or virtually anything else that can be considered an investment.

Taxation of Capital Gains

The tax rules for capital gains vary depending upon the specific investment, the length of time the asset was held, as well as your personal income tax rate. There are generally three considerations when it comes to determining the tax treatment of your capital gains. These are:

  1. How long have you held the investment? Generally speaking, you will pay a higher tax on investments you hold for less than a year, while paying less if you hold them for longer than that. This is to encourage long-term investing. According to the IRS, the clock begins the day you purchase your investment and ends the day you sell it. Assets that are held for less than a year are taxed at the same rate as your normal income. Assets held longer will be taxed at a long-term rate, which is 15% for most people. It is 20% for individuals who make more than $425,800 and zero if you earn less than $38,600.
  2. Are the capital gains being offset by capital losses? Capital losses are the opposite of capital gains. Instead of selling your investment for a profit; you sell them at a loss. Most of the time, you can offset any capital gains taxes you would owe by deducting capital losses on similar investments. For instance, if you had a $100,000 long-term capital gain on one stock and a $30,000 long-term capital loss on another stock, you might be able to pay taxes on the net capital gains of $70,000, saving you money.
  3. What is the tax treatment for the underlying asset on capital gains? The Internal Revenue Service taxes assets differently. While most investors will be selling stocks and bonds, some others may invest in collectibles, such as gold and silver bars, which are taxed at a different rate. It helps to understand how assets are taxed before you make a purchase.

Avoiding Capital Gains Taxes

In addition to offsetting gains with losses as explained above, you can avoid paying capital gains taxes if you invest using certain kinds of accounts. Specifically, a Roth Individual Retirement Account (IRA) allows you to invest as much as $6,000 annually, and you will not be on the hook for any taxes from the gains on those funds. The big caveat is that you can't withdraw the money until you are age 59 1/2.

Some education plans, such as the 529 College Savings Plan, will also allow you to avoid paying capital gains taxes as long as money is used to pay for qualified education expenses. New updates to the tax code allow you to save for not only college, but secondary and even elementary schools in this way.

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