Capital Gains Tax Guide for Investors
When your investment rises in value, there’s usually a tax implication
When you sell a valuable asset such as real estate or stock, you often end up with a capital gain. In most cases, a capital gain is the difference between the amount you paid for the asset and the higher amount for which you sold it.
As with other types of financial gains, the Internal Revenue Service (IRS) expects you to pay taxes on these capital gains. The tax rate you’ll pay depends on a couple of factors, including whether it’s a short-term or long-term financial gain and your taxable income.
Capital gains taxes apply in cases where you sell an asset for more than you paid for it—if you sell it for less, then a capital loss has occurred and you may be able to use it as a tax deduction.
Short-Term vs. Long-Term Capital Gains
A capital gain is the profit you earn from selling an asset for more than you paid for it. These gains are subject to capital gains taxes. Capital gains are taxed depending on how long you held the asset before selling it. A short-term capital gain occurs when you hold an asset for less than one year and then sell for a profit.
Let’s say you buy stock in your favorite company. A few months later, the stock’s price goes up, and you decide to sell your shares to lock in your gains. Because you’ve held the stock for less than one year, the money you make is considered a short-term capital gain.
A long-term capital gain occurs in cases where you sell for a profit after holding an asset for more than one year. If you had purchased that same stock but held onto your shares for a few years rather than a few months, then selling for a profit would result in a long-term capital gain.
Long-Term Capital Gains Tax
Long-term capital gains taxes apply when you sell an asset at a profit after holding it for more than one year. The tax rate on these gains ranges from 0% to 20%, depending on your annual taxable income.
Single taxpayers earning $39,375 or less and married taxpayers earning $78,750 or less will pay no taxes on their long-term capital gains. If you’re single, earning between $39,376 and $434,550, or married and earning between $78,751 and $488,850, your capital gains tax rate will be 15%. Finally, a capital gains tax rate of 20% applies to single taxpayers earning $434,551 or more and married taxpayers earning $488,851 or more.
A common example of when you might pay long-term capital gains taxes (or not pay them, depending on your income) would be the case of buy-and-hold investing. People who use this strategy often put their money into investments such as index funds or exchange-traded funds (ETFs) and then hold them for long periods, often many years. When you ultimately sell your investments, any profits you’ve made could be subject to long-term capital gains.
|Capital Gains Tax Rate||Taxable Income, Single||Taxable Income, Married Filing Separately||Taxable Income, Head of Household||Taxable Income, Married Filing Jointly|
|0%||$0 to $39,375||$0 to $39,375||$0 to $52,750||$0 to $78,750|
|15%||$39,376 to $434,550||$39,376 to $434,550||$52,751 to $461,700||$78,751 to $488,850|
|20%||$434,551 or more||$244,426 or more||$461,701 or more||$488,851 or more|
Short-Term Capital Gains Tax
A short-term capital gain tax applies when you sell an asset after holding it for less than one year. Unlike long-term capital gains, short-term capital gains are taxed as ordinary, or regular, income. As a result, you can expect to pay taxes on these gains at the same rate you’d pay in income taxes. Depending on how much you earn, you could pay anywhere from 10% to 37% on these gains.
Investors who may find themselves paying short-term capital gains taxes include day traders who buy and sell shares throughout the day in an effort to time the market.
Suppose you decided to try your hand at day trading and make a profit of $1,000 throughout the year. When tax time rolls around, you’ll pay taxes on these gains at the same rate as your ordinary income. So if you end the year with $50,000 in taxable income, including your day trading profits, then you can expect to pay tax as high as 22% on that portion of your income.
How to Reduce Capital Gains Taxes
Hold Your Investments Longer
The long-term capital gains tax rate is usually significantly lower than the rate for short-term capital gains. Consider this: An individual making up to $39,375 in taxable income or a married couple making up to $78,750 will pay no taxes at all on a long-term capital gain. Yet the same people would pay up to 12% for a short-term capital gain. And for especially high earners, the difference could be 20% for long-term capital gains versus 37% for short-term capital gains.
One of the easiest ways to reduce your capital gains taxes is to hold your asset for at least one year.
Invest in Tax-Advantaged Retirement Accounts
Tax-advantaged retirement accounts such as 401(k)s and individual retirement accounts (IRAs) aren’t subject to the same capital gains taxes that other investments are. Investors can buy and sell assets within these accounts without worrying about paying capital gains taxes. These tax-advantaged rules also apply to 529 college savings plans.
Tax Advantage of Tax-Loss Harvesting
Tax-loss harvesting is a strategy that involves selling securities at a loss and then immediately repurchasing them. This strategy is often used to offset any potential capital gains, thus reducing your overall tax liability. Many robo advisors automatically employ this tactic for their customers.
Unusual Capital Gains Situations
While the short-term and long-term capital gains rules apply to many investments, there are a handful of exceptions.
Capital Gains on Your Primary Residence
When you sell your primary residence, you might be able to exclude some of the profits from capital gains tax. You may exclude the first $250,000 (or $500,000 for married couples) of your capital gain from taxes if:
- You owned the home for at least two of the past five years
- You owned the home and used it as your residence for at least two of the past five years
- You didn’t sell another home during the two years before the date of sale or didn’t take an exclusion from the sale
Capital Gains on Collectibles
The tax rate on capital gains from the sale of collectibles, such as coins or art, is 28%.
Capital Gains on Depreciated Property
The IRS taxes unrecaptured Section 1250 gains at a rate of 25%. This section of the tax code applies to property you own that has depreciated in value over time, resulting in a tax break.
Capital Gains on Small Business Stock
If you sell qualified small business stock and receive a capital gain, you’ll be taxed at a rate of 28%.
Net Investment Income Tax
Depending on your annual income, you might also be subject to the net investment income tax (NIIT). This rule results in an additional 3.8% tax to certain investment income for single filers with a modified adjusted gross income (MAGI) of $200,000 or more, and married individuals filing jointly with a MAGI of $250,000 or more.
Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed Nov. 4, 2020.
Internal Revenue Service. "2019 Publication 550." Accessed Nov. 4, 2020.
Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2020." Accessed Nov. 4, 2020.
Internal Revenue Service. "2019 Publication 523." Accessed Nov. 4, 2020.
Internal Revenue Service. "Questions and Answers on the Net Investment Income Tax." Accessed Nov. 4, 2020.