Understanding Capital Gains Tax for Beginners

The tax process can be confusing, especially if you’re new to investing. But understanding key terms can help you minimize capital gains taxes.

Capital gains are profits made when you sell a capital asset (like stocks, mutual funds, property or cryptocurrency) for more than what you paid for it. The IRS considers these profits income, and they must be reported on your tax return.

What is capital gains tax?

Capital gains tax is a form of income tax that applies to the profit you make when selling certain assets. It is typically lower than the ordinary income tax rate. The amount of your capital gains depends on how long you have held the asset and the type of asset you are selling.

Gains on the sale of traditional investments like stocks and bonds are taxable, as are real estate and other valuable personal property such as jewelry, artwork, or collectibles. Capital gains taxes are also applied to the sale of cryptocurrency.

The tax treatment of capital gains varies widely, so be sure to work with a tax professional. Some states don’t have a capital gains tax at all, while others treat it differently than ordinary income. If you sell your home, for example, you can exclude up to $250,000 in gains if you are single or $500,000 if you are married filing jointly. However, this exclusion doesn’t apply to withdrawals from tax-advantaged accounts like 401(k) plans and IRAs1. In these cases, you will pay regular income tax on your capital gains.

Short-term vs. long-term gains

Capital gains taxes are taxed differently for investments held for a longer or shorter period. Short-term capital gains are taxed at a higher rate than long-term ones. However, you can use your capital losses to offset your taxable gains without any limit.

To calculate your net capital gains, add your long-term and short-term gains together and subtract any unused long-term losses carried over from previous years from the total. This is the amount you would report on your IRS Form 1040.

Capital gains taxes are a big part of your overall investment strategy, so it’s important to understand how they work and how they can affect your wealth management plan. The various tax rates, holding periods and special rules can be complex, so it’s wise to consult a tax professional or financial planner for personalized guidance. In addition, investors should consider strategies that can minimize their capital gains taxes, such as investing in tax-advantaged accounts, minimizing frequent trading or “churning” and strategically timing investment sales. Lastly, many states offer exemptions, deductions or credits on capital gains.

Tax rates

When an investment appreciates, it’s known as a capital gain. This profit is taxed when it’s sold, and the rate depends on how long you own the asset and your income level that year. Some assets are exempt from capital gains tax, such as a principal private residence, and investments in start up enterprises may be eligible for lower rates of tax through entrepreneurs’ relief.

For most people, the rate for long-term gains is 15% or less. That’s a good thing, since it helps lower your overall taxes. However, some high earners who are in the 37% income tax bracket might pay a higher rate of 20%. It’s important to consider the tax rate when making your decisions, especially if you plan to sell any investments within the next few years. You’ll want to make sure you’re taking advantage of any available deductions and exemptions. Also, remember that your state might have its own capital gains taxes in addition to the federal one. These additional state rates can add up quickly.

Exemptions

There are a variety of rules and exemptions that can impact capital gains tax. These include rules on the sale of investment assets, such as stocks, bonds, mutual funds, and cryptocurrency, and property. For example, homeowners typically do not need to pay capital gains taxes when they sell their home. This is a result of the Taxpayer Relief Act of 1997, which exempts a single taxpayer from paying up to $250,000 in capital gains on their home, and married taxpayers can exclude up to $500,000. More information about this tax exemption can be found in IRS Publication 523, Selling Your Home.

It is important to understand the intricacies of capital gains tax, as it can have a significant impact on your financial decisions and investments. For this reason, it is crucial to seek professional guidance from a tax professional and/or financial planner. To avoid high capital gains tax rates, it is recommended to hold assets for at least a year before selling them. However, this may not always be practical, especially for people who are active investors.

Reporting requirements

Capital gains tax can be confusing, but getting a handle on the basics makes it easier to navigate. With a solid foundation in the key terms, you can better understand how to calculate profits, determine whether an investment qualifies as a capital gain and what rates apply to it.

Investors should also keep in mind that a portion of their capital gains may be deferred if they contribute the proceeds to charity or reinvest them into new assets within a certain time period after the sale. This can reduce your taxable income for the year and potentially lower your overall tax rate.

Keeping detailed records of your transactions is another way to avoid misunderstandings and mistakes that can impact your tax liability. Save receipts, contractor invoices and even before/after photos to help you accurately track your cost basis and identify deductible expenses, such as home improvements that increase your selling price and qualify for preferential tax rates. If you have questions, consult with a Jackson Hewitt Tax Pro for guidance.