What Is Capital Gains Tax Exactly?
Just as the government expects to receive a cut of your income, it also levies a tax on profits you receive on your investments. This is known as capital gains tax.
The definition of a capital gain
A taxable capital gain is a realized increase in asset value. An increase in asset value is not taxable until it is “realized” when the asset is sold. Unrealized gains, also known as “paper gains,” may increase the investment’s value. Nevertheless, such a gain only becomes taxable when the investor liquidates the asset.
Conversely, where an investor sees their capital asset decrease in value, this results in a capital loss. Just like a gain, a capital loss is only realized when the asset is sold. Taxpayers can reduce their taxable income by offsetting capital losses against capital gains, reducing their tax liability.
Capital gains apply to a variety of different asset types, including real estate, automobiles, jewelry, and works of art and other collectibles. Due to their inherent price volatility, stocks and investment funds are a common source of capital gains and losses.
Different assets trigger different capital gains tax treatment. Some asset classes, such as depreciable business property and business inventory, are exempt from capital gains tax.
Noncapital assets created or commissioned by an individual are also exempt from capital gains tax. Examples of this category of assets include:
· Musical, artistic, and literary compositions
· Speeches, transcripts, manuscripts, and recordings
· Photographs and drawings
· Copyrights, patents, inventions, designs, and secret formulas
Short-term and long-term capital gains tax
Investors realize a long-term capital gain on an asset that they have held for 12 months or more. If the investor retained the asset for less than 12 months before liquidating it, it is classed as a short-term capital gain. There are limited exceptions to this 12-month rule, as stipulated on the IRS website.
It is important to distinguish between long-term and short-term capital gains since they attract different rates of taxation. The US tax system is set up to benefit long-term investors. In the case of short-term gains, these are taxed at the ordinary income tax rate, with long-term capital gains taxed at a different, typically lower rate.
As of 2021, while short-term capital gains follow the ordinary 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 25 percent, and 37 percent income tax rates, long-term capital gains tax rates are calculated according to the taxpayer’s taxable income as delineated below.
Status
0%
15%
20%
Single
< $40,400
$40,401 — $445,850
> $445,850
Married filing separately
< $40,400
$40,401 — $250,800
> $250,800
Surviving spouse or married filing jointly
<$80,800
$80,801 — $501,600
>$501,600
Head of household
<$54,100
$54,101 — $473,750
>$473,750
Special types of capital gains tax
Certain types of assets attract special capital gains tax treatment. For example:
· Where a taxpayer realizes a gain when selling their principal residence, the first $250,000 of a gain is tax free, provided that they have lived in that home for at least two years. In the case of a married couple filing jointly, the first $500,000 is shielded from capital gains tax.
· A 28 percent tax rate is applied to gains realized via the sale of qualified business stock.
· Gains on collectibles, such as works of art, are taxed at 28 percent.
Mitigating capital gains tax
High-income taxpayers can reduce their capital gains tax liability via several routes.
In any single tax year, a taxpayer may gift up to $15,000 per person to an unlimited number of beneficiaries. Where a taxpayer gifts highly appreciated stock to their parent or child, the gain does not become taxable until the parent or child liquidates the asset. Provided that the beneficiary falls within the lowest tax bracket, the gift will not trigger tax liabilities. By leveraging this tax-saving opportunity, a family could potentially reduce a 23.8 percent tax bill to zero, although new rules apply where the beneficiary is under the age of 24.
Charitable donations remain an effective method of reducing capital gains tax liabilities, particularly where gifts are made in the form of appreciated stock. With long-term capital gains incurring lower tax rates than short-term gains, concentrating on long-term investments rather than short-term is an effective way of reducing your tax bill.
Nevertheless, identifying the right companies to invest in to maintain long-term profitability is easier said than done. An enterprise’s fortunes can change unpredictably over the years, and you may need to sell earlier than you anticipated.
The bottom line
From tax-deferred retirement plans to using capital losses to offset capital gains, taxpayers looking to reduce their capital gains tax liability have several options.
Nobody wants to pay more tax than they need to. With as much as 37 percent of annual income swallowed up by taxes, most high-wage earners are keen to minimize their return. For high-net-worth taxpayers, seeking out advice from seasoned professionals could potentially save them thousands.
