A capital gain is a profit made from the sale of a capital asset. The sales price exceeds the cost of the investment, referred to as the cost basis. You've incurred a deductible capital loss when you've lost money on an investment.
You'd have a capital gain of $3,000 if you sold an asset for $6,000 and your cost basis was $3,000. You'd have a $3,000 capital loss if you sold the asset for $3,000 but your cost basis was $6,000. The equation is basically sales price less basis.
What Is a Capital Asset?
Capital assets are investments such as stocks, mutual funds, bonds, real estate, precious metals, coins, fine art, and other collectibles. You're taxed on the change in value if your investment has an increase in value when a capital asset is sold.
What Is Cost Basis?
Cost basis is the original price you pay for a capital asset, plus any associated costs, such as commissions paid to brokers. An asset's cost basis must be adjusted up or down to reflect its true cost for tax purposes in some cases. This is referred to as an "adjusted basis," and it's calculated by beginning with the original cost basis, then making adjustments that either increase or decrease that basis.
Tax Treatment of Capital Losses
When you realize a loss on a capital asset by selling it for lower than your cost basis, you may be able to benefit from that loss for tax purposes. One way to do that is to offset your capital gains by using that capital loss.
You can also claim up to $3,000 or $1,500 (if married filing separately) in capital losses as a tax deduction for the 2021 tax year —the return you'd file in 2022. You can carry any unused balance forward to subsequent tax years if your losses exceed this amount. This is subject to a host of rules, however.
For example, if you incurred a $10,000 loss this year but also realized capital gains of $2,000 on your stock portfolio, you could offset that gain against your loss as well as claim $3,000 ($1,500 if married filing separately) as a capital loss deduction. You'd be able to carry forward and claim the remaining $5,000 as capital loss deduction in future years.
Losses realized on the purchase and sale of personal property, such as your home or car, aren't deductible.
Short-Term vs. Long-Term Gains
Capital gains are taxed depending on what kind of capital asset you've invested in and how long you held that asset. Gains are grouped into short-term and long-term holding periods for tax purposes. The short-term holding period is one year or less. The long-term holding period is more than one year.
Short-term gains are taxed at ordinary income tax rates according to your tax bracket. Long-term capital gains are taxed at their own long-term capital gains rates, which are less than most ordinary tax rates. The long-term capital gains tax rate is either 0%, 15%, or 20% as of 2021, depending on your overall taxable income. Some other types of assets might be taxed at a higher rate.
It can be worth it to consider waiting until you've owned an asset for one year and one day if you're on the cusp of selling an asset that will likely result in a profit.
Tax planning for investors focuses on deferring the sale of profitable investments until you qualify for the discounted long-term capital gains tax rate.
Long-Term Capital Gains Tax Rates
Long-term capital gains tax rates are somewhat different from what they were in the past due to provisions of the Tax Cuts and Jobs Act (TCJA) of 2017. These rates were once tied to ordinary income tax brackets.
Long-term, capital gains tax brackets as of 2021 are as follows:
|Tax Rate||Single Taxpayers||Married Filing Separately||Married Filing Jointly||Heads of Household|
|0%||$0 - $40,400||$0 - $40,400||$0 - $80,800||$0 - $54,100|
|15%||$40,401 - $445,850||$40,401 – $250,800||$80,801 - $501,600||$54,101 - $473,750|
|20%||$445,851 or more||$250,801 or more||$501,601 or more||$473,751 or more|
Short-term gains tax rates have changed somewhat as well under the TCJA because the law alters ordinary income tax brackets. The income spans attributable to these brackets are adjusted for inflation as well.
Talk to a tax professional if you realize a capital gain during the tax year. You might be required to make estimated tax payments on that amount to avoid a tax penalty.
Tax Treatment of Other Investments
Short-term gains on collectibles, assets that subject to appreciation recapture, and qualified small business stock are also taxed at ordinary income tax rates, but long-term gains on these assets are taxed at their own rates:
- Collectibles: 28%
- Depreciation recapture: 25%
- Qualified small business stock: 28%
Long-term investments in collectibles are taxed at a flat 28%. Collectibles include:
- Precious metals
- Precious gems
- Rare rugs
- Alcoholic beverages
- Fine art
Some precious metal coins and bullion are considered regular investment assets. They're not collectibles for tax purposes.
Real Property That's Been Depreciated
Real property that has been depreciated is subject to a special depreciation recapture tax. A 25% tax rate applies to the amount of gain that's related to depreciation deductions that were claimed or could have been claimed on a property. The remainder of the gain is taxed at ordinary tax rates or at long-term capital gain tax rates, depending on how long the property was held.
Gains and Losses on Small Business Stock
Capital gains and losses on small business stock might qualify for preferential tax treatment.
Under Internal Revenue Code section 1202, 100% of the gains made from sale of stock of a "qualified small business" can be excluded from gross income if among other things it met the following criteria:
- The stock was purchased after the enactment of the Creating Small Business Jobs Act of 2010 or Sept. 27, 2010.
- The stock was held for more than five years
- The gain does not exceed $10 million ($5 million for married filing separately) or 10x the adjusted basis
- The small business is organized as a C corporation
- The company's gross assets did not exceed $50 million immediately before or after the stock issuance
Losses incurred from the sale of small business stock may be treated as ordinary losses up to $50,000 per year (or $100,000 per year if married filing jointly), under Section 1244 of the Internal Revenue Code. To qualify for this treatment, the paid-up capital for the small business must not exceed $1 million.
Small business investors can request that companies certify their stock as qualifying under Section 1202, Section 1244, or both at the time they make an investment in the company.
Fixed Assets in a Business
If you are a business owner yourself, gains from sale of business property are taxed as ordinary gains. Business assets include all furniture, equipment, and machinery used in a business venture. Examples include computers, desks, chairs, and photocopiers. Ordinary gains are reported on IRS Form 4797.
A Capital Gains Exclusion
An important distinction exists between real estate that's held as an investment and real estate that serves as a taxpayer's primary residence. In the case of personal residences, $250,000 in profit is excluded from capital gains tax for individual taxpayers, and this increases to $500,000 for taxpayers who are married and file joint returns.
The taxpayer must have owned and lived in the home for at least two of the last five years preceding the sale to qualify for the home sale exclusion, and other rules apply as well.
Keep Investment Records
Investors should keep careful track of their investments. This information is essential for calculating the amount of a capital gain. You must know how much you invested, your brokerage fees and commissions, and when you bought the investment. You must also know the date of sale for your investment, the gross proceeds from the sale, and any fees or commissions you paid in the sale.
You might want to use a spreadsheet or personal finance software to keep track of this information. Personal finance programs can provide more robust investment tracking features than spreadsheets. Your broker might also have tools for tracking cost basis, gains, and losses.
Retain any reports and trade confirmations as backup documentation. Annual reports from your broker are especially helpful, and these should be kept along with your other tax-related documents. Trade confirmations and gain/loss reports will come in handy when you're preparing your tax return.
Frequently Asked Questions (FAQs)
How do you avoid paying capital gains taxes on stocks?
There are only three ways in which an investor can avoid paying capital gains on stocks. First, they can trade the stock in a tax-sheltered account, such as a Roth IRA. Second, they can sell a separate stock at a loss to cancel out the profits, this is called tax-loss harvesting. Third, they can avoid paying capital gains taxes by avoiding selling stock. If you have a net profit from capital gains in a taxable account, you can't avoid capital gains taxes.
When do you pay capital gains taxes?
You are liable to pay capital gains tax if your income meets a certain threshold and you incur a net capital gain during the tax year. If you're a relatively small-time investor who has a few hundred dollars in total profit on the year, then you will settle your capital gains tax liability when you file your tax returns. However, if you expect to owe at least $1,000 when you file your returns, then you must calculate and pay quarterly estimated taxes.
Internal Revenue Service. "Topic No. 409 Capital Gains and Losses."
Internal Revenue Service. "Part 5. Collecting Process."
Internal Revenue Service. "Capital Gains, Losses, and Sale of Home."
Internal Revenue Service. "26 CFR 601.602: Tax forms and instructions," Page 8.
Internal Revenue Service. "Issue Snapshot - Investments in Collectibles in Individually-Directed Qualified Plan Accounts."
Internal Revenue Service. "FAQs: Property (Basis, Sale of Home, etc.) 5."
Small Business Administration. "Small Business Jobs Act of 2010."
Office of the Law Revision Counsel of the United States House of Representatives. "26 USC 1202: Partial Exclusion for Gain from Certain Small Business Stock."
Office of the Law Revision Counsel of the United States House of Representatives. "26 USC 1244: Losses on small business stock."
Small Business Administration. "Buy Assets and Equipment."
Internal Revenue Service. "About Form 4797, Sales of Business Property."
Internal Revenue Service. "Topic No. 701 Sale of Your Home."