Updated: Oct 15
When you hear ‘capital gains’ you usually think of the taxes you pay when you sell a stock for a gain. But taxes are applied on almost all of capital gains you achieve on any investment.
Capital gains are profits from the sale of a capital asset, such as shares of stock, a business, a parcel of land, or artwork that you own. Capital gains are generally included in taxable income, but in most cases, are taxed at a lower rate.
Unfortunately, the bad news is that, yes, capital gains will push up your adjusted gross income. But it will not cause your ‘ordinary income’ to be taxed at a higher rate.
The good news is capital gains are taxed separately from your ‘ordinary income’. Your ordinary income is taxed first on the tax bracket that you fall into, then the capital gains tax you owe is calculated in the gain you received when you sold your long-term investment. (see table 1. below).
A capital gain is locked-in when a capital asset is sold or exchanged at a price higher than its basis. Basis, or cost basis is an asset’s purchase price, plus commissions and the cost of improvements less depreciation. A capital loss occurs when an asset is sold for less than its basis. Gains and losses (like other forms of capital income and expense) are not adjusted for inflation.
Long and Short Gains
Capital gains and losses are classified as long term if the asset was held for more than one year, and short term if held for a year or less. Short-term capital gains are taxed as ordinary income at rates up to 37 percent; long-term gains are taxed at lower rates, up to 20 percent.
Table 1. Long-Term Capital Gains Tax Rate by Filing Status and Taxable Income
What individuals are subject to the Net Investment Income Tax ("Medicare Tax")?
Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:
Table 2. Net Investment Income Tax/3.8% Medicare Tax
The Tax on Capital Gains has Changed Over the Years
For most of the history of the income tax, long-term capital gains have been taxed at lower rates than ordinary income
The maximum long-term capital gains and ordinary income tax rates were equal in 1988 through 1990. Since 2003, qualified dividends have also been taxed at the lower rates.
The Tax Cuts and Jobs Act (TCJA), enacted at the end of 2017, retained the preferential tax rates on long-term capital gains and the 3.8 percent net investment income tax. This 3.8% tax was enacted to pay for Medicare expansion, as part of the Affordable Care act 2010, under the Obama administration.
TCJA separated the tax rate thresholds for capital gains from the tax brackets for ordinary income for taxpayers with higher incomes the thresholds for the new capital gains tax brackets are indexed for inflation, but, as under prior law, the income thresholds for the NIIT (the additional 3.8% Medicare surcharge tax) are not.
TCJA also eliminated the phaseout of itemized deductions, which had raised the maximum capital gains tax rate above the 23.8 percent statutory rate in some cases.
Confused yet? Maybe this Graph will help:
Above: Figure 1.: Contrasting long-term capital gains tax brackets from pre-Tax Cuts and Jobs Act and under current law, by filing status (Source: Tax Policy Center)
Capital Gains Tax – Not Just for the Stock Market
There are special rules for certain types of capital gains. Gains on art and collectibles are taxed as ordinary income tax rates up to a maximum rate of 28 percent.
Up to $250,000 ($500,000 for married couples) of capital gains from the sale of principal residences is tax-free if taxpayers meet certain conditions including having lived in the house for at least 2 of the previous 5 years.
Up to the greater of $10 million of capital gains or 10 times the basis on stock held for more than five years in a qualified domestic C corporation with gross assets under $50 million on the date of the stock’s issuance are excluded from taxation.
C corporations pay the regular corporation tax rates on the full amount of their capital gains and may use capital losses only to offset capital gains, not other kinds of income.
Also excluded from taxation are capital gains from investments held for at least 10 years in designated Opportunity Funds.
This investment incentivizes investments in areas of the country with economically distressed communities. Gains on Opportunity Fund investments held between 5 and 10 years are eligible for a partial exclusion.
Let’s review some strategies that can lower the tax you pay.
Capital losses may be used to offset capital gains, along with up to $3,000 of other taxable income. The unused portion of a capital loss may be carried over to future years.
The tax basis for an asset received as a gift equals the donor’s basis. However, the basis of an inherited asset is “stepped up” to the value of the asset on the date of the donor’s death. The step-up provision effectively exempts from income tax any gains on assets held until death.
Roth IRA conversion
Converting a pre-tax retirement account into a Roth account is a powerful tool in tax planning if done right. It can be tricky because many factors need to be just right for it to be of benefit to you.
What it is: your pre-tax retirement account is converted to a Roth account, which is an account where the tax have already been paid on the funds in the Roth account. That way the funds can grow without worrying about paying any further taxes on that money (as long as you follow the rules on then you can start taking funds from the account).
You need the right length of time for the account to grow, estimate what that your tax rate will be in the future and calculate that you will have other income sources when you want to begin taking withdrawals from your other retirement accounts for this strategy to work to lower your taxes.
When you take capital gains on your appreciated assets will also play a part in planning a Roth conversion. It’s something to consider.
Careful planning with a professional to crunch the numbers can save you a considerable amount on what you might already be overpaying in taxes. With proactive planning you can keep more of your money in your pocket instead of handing it over to Uncle Sam. Contact us to learn if these strategies makes sense for you.