Capital Gains Tax Guide for Investors

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A Quick Step-By-Step Guide to Understanding Capital Gains Tax Rates and Rules

Capital gains tax rates filing
This guide to capital gains tax rates and rules was designed to help you discover how much you may owe based on the type of investment you own (stock, bond, mutual fund, real estate, gold, small business, or art, for instance), and how long you owned it. Getty Images

In the special, Capital Gains Tax Guide for New Investors, you learned what capital gains are, how the length of time you hold an investment helps determine you capital gains tax rate, and much more. This step-by-step guide is more like a cheat sheet that will provide you with a wealth of information on capital gains taxes and capital gains tax rates including:

 

  • Short-term capital gains tax rates
  • Long-term capital gains tax rates
  • Collectible capital gains tax rates (which includes gold and silver)
  • Small business capital gains tax rates including section 1202 stocks
  • Real estate capital gains tax rates

It should provide you with a lot more information so you aren't afraid to ask your accountant or tax preparer specific questions when it comes time to write your check to the IRS. It's still important you consult with a qualified and well respected tax adviser because there are a number of factors that may cause your capital gains tax rate to be different. For instance, if you lost a lot of money several years ago, you may have what is known as a capital gains tax loss carry forward. That means that you might be able to write off any capital gains profits from this year against those old losses.

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Short-Term Capital Gains Tax Rates

Short Term Capital Gains Tax Rates
Short-term capital gains tax rates are based upon your personal income tax rates. Put simply, if you own a stock for less than one year, you are going to be taxed on any gain at the same rate you pay income taxes. A 35% bracket person would pay 35%. Getty Images

The short-term capital gains tax rate is based upon your personal income tax rate (currently capped at 35%) and applies to stocks, bonds, mutual funds, real estate investment trusts, or other investments that have been held for less than one year. For instance, someone in the 35% tax bracket who made a $50,000 short-term capital gain would pay taxes of $17,500 ($50,000 x 35% = $17,500 short-term capital gains tax liability).

 

The Connection Between Short-Term Capital Gains Tax Rates and Portfolio Turnover

Short-term capital gains taxes can take a huge bite out of your investment returns and is one of the reasons investors who use a value investing philosophy focus on lowering turnover in their portfolios. Famous money management firms such as Tweedy, Browne have released research reports showing that it's possible to generate higher wealth over long periods of time by keeping short-term capital gains low than it is getting a slightly higher return and being stuck with full taxation on your profits.

Of course, short-term capital gains taxes aren't applied to investments held in tax-advantaged accounts such as a Roth IRA or 401(k). That's one of the features that makes these types of account so attractive to investors who want to learn how to invest in stock or buy their first mutual fund.

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Long-Term Capital Gains Tax Rates

Long-Term Capital Gains Taxes Rates
Long-term capital gains tax rates are often substantially lower than short-term capital gains tax rates to encourage investment in businesses. This creates jobs, helps grow the economy, and increase the standard of living for the average worker. Getty Images

If you hold an investment for more than one year, you qualify for long-term capital gains tax treatment. This is an advantage to you that leaves more cash in your pocket because the long-term capital gains tax rate paid on investments such as bonds, stocks, and mutual funds is lower than most other tax rates.

 

  • Low Capital Gains Tax Bracket: Taxpayers in the 10% and 15 tax brackets will pay only 5% on profits earned from long-term capital gains. For investments bought between 2008 and 2010, they will pay zero percent - that's right, 0%, or absolutely nothing.
  • High Capital Gains Tax Bracket: Taxpayers in the 28%, 33%, and 35% tax brackets pay only 15% in capital gains taxes.

 

Potential Changes in the Long-Term Capital Gains Tax Rate

President Obama's budget calls for the lower long-term capital gains tax rates to sunset and expire. If this is permitted, the tax rates will go back to their pre-2003 level, which is 20% on all long-term profits.

 

Why the Long-Term Capital Gains Tax Rate Is Different than Short-Term Capital Gains Tax Rate

The reason for this capital gains tax rate structure is simple. The United States government wants to encourage long-term investment in our nation's economy. This treatment of long-term capital gains versus regular taxable income makes profits from investments more attractive than profits from actively working. Although it may seem unfair that a well-heeled, white-collar investor pays a lower tax on profits earned from selling shares of stock than a hardworking plumber, the theory behind it is that the money put to work in the business by the investor is going to create, ultimately, far more jobs because it will be used by the company in which he invested to build new factories, hire new secretaries, managers, executives, and mail room clerks, paint the walls, install new phone lines, launch new products, and much more. If the capital gains tax rates were higher for long-term investors, they would most likely ship cash outside of the country and invest in more friendly countries. This phenomenon is known as "flight of capital".

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Capital Gains Tax Rates on Collectibles

Investing In Art and Collectibles
If you invest in art, gold, silver, coins, stamps, wine, books, or virtually anything else that can be labeled a collectible, then the special collectible capital gains taxes probably apply to you. These rates are higher than regular capital gains taxes.

As you learned in Investing in Collectibles, owning collectibles such as bottles of wine, rare stamps, books, coins, or antiques, is now not only popular, it's possible in countries such as the United States and Great Britain to hold these assets in tax-advantaged retirement accounts. For most investors, though, they are more likely to invest in collectibles without the protection of a tax shelter. They buy great works of art, for instance, and they or their heirs sell it several decades later, generating large capital gains.

How are the capital gains tax rates for collectibles calculated? Currently, collectibles are taxed in two different tax brackets:

 

  • Short-Term Collectible Capital Gains Tax Rates: Collectibles held less than one year are taxed at personal income tax rates, just like short-term capital gains taxes on stocks or bonds.

     

  • Long-Term Collectible Capital Gains Tax Rates:: Collectibles held one year or longer are taxed at 28%. Thus, if you bought a Picasso for $100,000 several decades ago and sold it for $20,000,000 today, you would owe $5,572,000 in capital gains taxes ($20,000,000 sales price - $100,000 purchase price = $19,900,000 capital gain x 28% = $5,572,000 capital gains tax liability).

 

Gold and Silver Are Taxed as Collectibles

Gold and silver bullion, such as American Eagle gold coins, Canadian Gold Maple Leaf coins, and South African Krugerrand gold coins, are taxed at the same capital gains rate as collectibles. This includes Gold ETFs and Silver ETFs. Investors make a very real mistake assuming they will be able to pay the lower capital gains tax rate that is paid on stocks and bonds, sometimes causing them to experience painful surprises come tax day.

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Small Business Stock Gains Section 1202

Small Business Stock Gains Section 1202 Taxes
Small business stocks are sometimes eligible for special tax treatment under Section 1202 of the IRS code. In some cases, you can defer your capital gains indefinitely. In others, you can exclude up to 50% of your profits from the tax calculation. Getty Images

Individual investors may qualify for a special tax treatment on capital gains earned from small business stocks under section 1202 of the IRS code. Normally, small business stocks are taxed at 28% rates. There are actually several capital gains tax savings provisions that you can take advantage of to help you build wealth.

Here's how it works:

 

Exclusion of 50% of Capital Gains from the Capital Gains Tax Calculation

  • Shares of regular C Corporations that qualify under Section 1202, bought by investors that are not themselves corporations, that have a holding period of five (5) years or longer, can exclude 50% of the capital gain from the calculation of capital gains tax. In other words, if you made a $100,000 profit, you would only pay capital gains taxes on 50%, or $50,000.
  • This exclusion on the small business capital gains tax is limited to $10 million or 10 times the cost basis of your shares. If you bought your stock for $100,000 and it went to $2,000,000, for instance, you would have a gain of 20x your investment, exceeding the 10x limit.
  • From 2003 through 2011, this benefit is of limited value because the maximum capital gains tax on long-term capital gains profits is 15%.

 

Deferred Capital Gains Taxes on Section 1202 Small Business Stocks

You can also defer the gains you earn from small business stocks under a provision in IRC Section 1045. If you have held your shares for at least six (6) months, and you sell them, you won't have to pay the capital gains tax as long as you use the money to buy shares of another qualifying small business.

 

What Counts as a Qualified Small Business Stock Gain Section 1202 Profit?

According to Startup Company Lawyer, "Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993, up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements. Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify. In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time."

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Real Estate Capital Gains Taxes

Real Estate Capital Gains Tax Rate
Real estate capital gains taxes are some of the most generous tax rates available to investors, with exemptions that reach into the hundreds of thousands of dollars. By knowing real estate capital gains tax rules, you can make millions over your lifetime. Getty Images

Real estate capital gains taxes have some of the biggest loopholes and tax breaks for investors and homeowners, making them a fantastic way to build long-term wealth and achieve financial independence. These tax breaks are generally under-appreciated by most investors.

 

Real Estate Capital Gains Taxes for Homeowners

If you own a home, you can exclude up to $250,000 in capital gains profits from your capital gains taxes. For married couples, this figure is bumped to $500,000. Given that the median household net worth is only $120,300, this covers a vast majority of the nation's households. You must live in the house at least two years to qualify.

Thanks to the Taxpayer Relief Act of 1997, this exclusion on real estate capital gains taxes for homeowners applies to every primary residence you purchase - it is not a once-in-a-lifetime tax break, as was the case with the old rules. That is, you can use your profits from selling your primary residence to spend any way you want and you won't have to pay a penny to the IRS in many cases if you qualify.

 

Real Estate Capital Gains Taxes on Investment Properties

When you make an investment in real estate, such as rental houses, apartment buildings, hotels, offices, or storage units, the real estate capital gains tax rates is either 5% or 15% depending upon your income level plus your state taxes, as long as you have held the asset for one year or longer.

You can also defer your real estate capital gains taxes by doing what is known as a 1031 tax-free exchange. When you sell your property, if you pour the money into another investment property of equal or greater value, you can defer those capital gains taxes. One caveat: If you've taken a lot of depreciation against your real estate, you may find that you have a very low tax cost basis, meaning that there are big capital gains built into your holdings.