Capital Gains Tax Guide for Investors

A capital gains tax is the tax you pay on the profit made from the sale of an investment. The type of investment sold and the length of time it was owned often determine the capital gains tax rate.

Short-Term Capital Gains Tax Rates

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The short-term capital gains tax rate is based on your income tax rate, which is capped at 35% as of the 2018 tax year and applies to stocks, bonds, mutual funds, real estate investment trusts (REITs), and other investments that have been held for less than one year. For instance, someone in the 35% tax bracket who earned $50,000 in short-term capital gains would owe $17,500 in taxes.

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. Firms such as Tweedy, Browne have released research reports showing that you're more likely to generate higher wealth over time by keeping short-term capital gains low than you are by getting a slightly higher return and paying full taxes on your profits.

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 make these type of accounts attractive to those who want to learn how to invest in stocks or buy their first mutual fund.

Long-Term Capital Gains Tax Rates

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If you hold an investment for more than one year, you qualify for the long-term capital gains tax rate, which is lower than most tax rates. Long-term capital gains are taxed at three rates: 0%, 15%, and 20%.

Individuals earning $39,375 or less, and married couples earning $78,750 or less, pay 0% on long-term capital gains; individuals earning $39,376–$434,550, and married couples earning $78,751–$488,850, pay 15%; and individuals earning more than $434,550, and married couples earning more than $488,850, pay 20%.

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

The purpose of this capital gains tax rate structure is that 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; this may seem unfair, but the theory behind this is that the money invested into companies is used to create value that ultimately benefits the greater society. This can include building new infrastructure, hiring more employees, launching new products, and research and development.

If the capital gains tax rates were higher for long-term investments, investors would likely ship cash outside of the country and invest in more investor-friendly countries, like Malaysia, Poland, or the Philippines. This phenomenon is known as "capital flight."

Capital Gains Tax Rates on Collectibles

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Individuals who own collectibles such as bottles of wine, rare stamps, books, coins, or antiques can 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, and they or their heirs sell it several decades later, generating large capital gains.

As of the 2018 tax year, collectibles are taxed in two different tax brackets divided by short-term and long-term. Collectibles held less than one year are taxed at personal income tax rates, just like short-term capital gains taxes on stocks or bonds. Collectibles held longer than one year 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 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.

Small Business Stock Gains Section 1202

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Small business stocks are normally taxed at 28%, but investors may qualify for special tax treatment on capital gains earned from small business stocks under Section 1202 of the IRS code.

Excluding 50% of Capital Gains From the Capital Gains Tax Calculation

Individual investors that buy shares of regular C Corporations that qualify under Section 1202, and have a holding period of at least five years, can exclude 50% of their capital gains from the calculation of capital gains tax. For example, if you made a $100,000 profit, you would only pay capital gains taxes on $50,000. This exclusion of the small business capital gains tax is limited to $10 million or 10 times the cost basis of your shares. If you bought your shares for $100,000 and they went to $2 million, you would have a gain of 20x on your investment, exceeding the 10x limit.

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 months and 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?

A qualified small business is a domestic C Corporation in which the aggregate gross assets of the company between August 10, 1993, up until the time of issuance have not exceeded $50 million. A stock will not qualify as a small business stock if at any point during the taxpayer’s holding period, the corporation failed to meet certain “active business” requirements. Stock issued by an S corporation does not qualify as a 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. 

Real Estate Capital Gains Taxes

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Real estate capital gains taxes have various loopholes and tax breaks for investors and homeowners, making them a fantastic way to build long-term wealth and achieve financial independence.

Real Estate Capital Gains Taxes for Homeowners

If you own a home and have lived in it for at least two years, you can exclude up to $250,000 ($500,000 if you're married) in capital gains profits from your capital gains taxes. This exclusion applies to every primary residence you purchase—it is not a once-in-a-lifetime tax break. 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 if you qualify.

Real Estate Capital Gains Taxes on Investment Properties

When you make a real estate investment—such as rental houses, apartment buildings, hotels, offices, or storage units—the real estate capital gains tax rate is either 0%, 15% or 20%, depending on your income

You can also defer your real estate capital gains taxes by doing what is known as a 1031 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 and there are big capital gains built into your holdings.