Capital Gains Tax, Explained
Understanding capital gains tax is crucial, including its calculation and the applicable tax rates.
Since capital gains tax affects many investment transactions, it plays a significant role in the overall tax landscape for millions of people.
What is capital gain?
A capital gain is the profit earned from selling or trading a "capital asset." Generally, a capital asset includes:
Investment property, such as stocks, bonds, cryptocurrency, real estate, and collectibles
Property held for personal use, such as a car, house, or home furnishings
However, various special rules can affect how your property is classified or treated as a capital asset, altering how you report the transaction and calculate your taxes.
For example, if you frequently sell to customers, the property sold might not be considered a capital asset but business inventory, with profits from these sales not taxed as capital gains.
When Are Capital Gains Taxed?
Capital gains are taxed in the year they are "realized," which typically occurs when you sell a capital asset. As long as you hold onto the asset, it can increase in value without being taxed. For instance, taking loans against a capital asset does not trigger a realization event or capital gains tax, so many real estate investors prefer to refinance properties instead of selling them.
If you sell only a portion of the stock you hold in a company and you acquire the stock on different dates, there are multiple ways to determine your basis. The first-in-first-out (FIFO) rule is commonly applied, meaning the stock you purchased is sold first.
However, you can also use specific identification to match each share you bought and sold, elect to use the last-in-first-out (LIFO) rule or apply the average cost basis for all shares sold. When selling stock acquired on different dates, such as through a dividend reinvestment plan, be sure to consider your accounting method carefully.
How to Calculate Capital Gain Tax
To calculate your taxable capital gain, subtract your "basis" in the asset from the amount you receive when you sell or exchange it. Your basis is usually the amount you paid for the asset. Sometimes, this calculation is straightforward: if you bought stock for $10 and sold it for $100, your capital gain is $90. However, in other cases, determining your basis can be more complex.
Capital Gains Tax Rates
Long-term capital gains are taxed at lower rates than short-term capital gains, which are taxed as ordinary income. Knowing the holding period of any asset you sell is essential. If you hold an asset for more than a year, the gain from its sale qualifies as a long-term capital gain and is taxed at reduced rates.
When selling only part of your stock in a company, your holding period is determined by your chosen accounting method (FIFO, LIFO, etc.). Additionally, if you acquired stock through means other than purchase or taxable transactions (e.g., inheritance), you might be able to count the previous owner's holding period.
For long-term gains, it's essential to determine which capital gains tax bracket you fall into: 0%, 15%, or 20%. Similar to ordinary income, the rate at which long-term capital gains are taxed depends on whether your taxable income falls above or below certain thresholds for the year.
