Not all income is created equal, and how you treat capital gains can make a pretty significant difference to your yearly tax bill. Read on to understand capital gains and how they can affect your bottom line. Then enlist the help of your CPA for tax planning strategies that let you keep more of what you earned.
What Are Capital Gains?
Capital gains are the increase in the value of an investment, business, property, or another tangible asset when you sell it. In other words, your profit. These gains are considered “realized” when you actually sell the asset. Before that, they’re referred to as “unrealized gains” and aren’t tax eligible.
Let’s say you buy an asset, and its value goes up 20%. Although the asset is now worth more, you won’t actually “realize” the benefit until you sell it.
Unlike regular income you earn by doing your job, capital gains income is considered “passive income” because you didn’t physically have to take any action to earn it.
The tax treatment of capital income at the federal and state level has been the subject of many heated discussions over the years. Some commentators think it should be taxed at the same rate as regular income or higher, while others believe it shouldn’t be taxed at all.
Is There Such A Thing As Capital Losses?
Unfortunately, yes. Capital losses, conversely, are the decrease in the value of an investment. While no one likes to lose money, we’ll discuss ways to use those losses to offset your taxes.
How Are Capital Gains (Or Losses) Determined?
To determine your net capital gains, you simply need to subtract the asset’s purchase price (or basis) from your selling price.
Let’s say you buy a piece of farmland for $300,000, and later you sell it for $500,000. Your capital gains would be $200,000.
Conversely, if you buy for $400,000 and sell for $200,000, you’ve just realized a capital loss of $20,000.
What’s The Difference Between Short- and Long-Term Capital Gains?
This is a simple — but critical — concept you need to know to avoid paying more in taxes.
Short-term capital gains are those made when you sell an asset you’ve owned for less than one year. Your profits are considered long-term capital gains if you wait to sell for at least one year after you’ve owned the asset, and the difference in the tax rate can be substantial.
What Is A Net Capital Gain?
Net capital gains are the overall profits you make from selling assets over the course of a particular tax year. In some instances, you might experience a capital loss instead of a capital gain.
Let’s say you purchase a stock that goes down in value instead of increasing. The money you lost if you sell the stock is a capital loss.
When you tally all the capital losses you made throughout the year and subtract them from your total capital gains, you arrive at your net capital gains for the year.
What Is The IRS Capital Gain Tax Rate For 2021?
For short-term capital gains, you pay taxes at the same level as the regular income you make from your salary. Long-term capital gains are currently taxed at a much lower rate by the IRS. In 2021, long-term capital gains are taxed as follows:
| Status | Income | IRS Capital Gains Tax Rate |
|---|---|---|
| Individual | Less than $80,000 | 0 |
| Individual | More than $80,000 but less than $441,450 | 15% |
| Married Filing Jointly or Qualifying Widower | More than $80,000 but less than $496,600 | 15% |
| Head of Household | More than $80,000 but less than $469,050 | 15% |
| Married, Filing Separately | More than $80,000 but less than $248,300 | 15% |
A net capital gain tax rate of 20% applies if your taxable income exceeds the thresholds set above.
Source: https://www.irs.gov/taxtopics/tc409
How Do States Tax Capital Gains?
When it comes to state taxes on net capital gains, every state is different. Some states, especially those without any income tax, consider capital gains to be tax-exempt, while states in high tax brackets like California could tax capital gains as high as 12.3%.
Ways to Reduce the Taxes Brought On By Capital Gains
Your CPA can help you apply tax strategies to reduce your annual tax bill. Some tactics to consider include the following:
- Apply Tax-Loss Harvesting. We mentioned above that you can offset your tax bill with capital losses on the sale of assets. With tax-loss harvesting, you use the sale of money-losing investments to reduce your net capital gains.
- Reduce Your Taxes on Ordinary Income. If you have more losses than capital gains for the year, you can use up to $3,000 to offset taxes on ordinary income (e.g., your salary) and even carry over the rest of the losses for use in subsequent years.
- Convert Your Account to a Roth IRA. Once you’ve converted your assets to this type of account, you can take advantage of tax-free wealth accumulation — including taxes you would normally pay on capital gains.
- Avoid Creating Short-Term Capital Gains. You can have a significant reduction on your tax bill if you wait to sell an asset until you’ve owned it for at least one year.
- Fund a 529 Plan. Reduce taxes by funding a 529 plan with up to the maximum annual tax-exempt gift. Or, if your goal is to transfer wealth, make a one-year contribution this year, and then “super-fund” the next five years in January for maximum benefit.
Taxes are ever-changing and unique to your particular situation, so it’s always a good idea to get the help of a tax professional — especially when applying more complex tax strategies.
For answers to all your tax questions, make an appointment with your CPA today.
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