Capital gains are taxes that all investors need to be knowledgeable of. Whether you invest in stocks, bonds, real estate, etc., capital gains taxes must be paid once the investment is eventually sold. Using tax planning or basic knowledge of capital gains taxes can help you prepare for the eventual tax bill without getting surprised. Below, I’ve outlined a guide to capital gains taxes!
Two Types of Capital Gains Taxes
There are two types of capital gains taxes. They vary based on the amount of time you hold an investment before selling it and “realizing” the gains. The first being short-term capital gains and the second being long-term. Fairly straightforward, right? Short-term capital gains are owed when you sell an investment that you’ve held for less than a year, and long-term capital gains are owed when you hold the investment for longer than one year.
The holding period of one year is a key item to remember. Suppose you have a significant gain on a stock investment, for example, that you’ve held for nearly one year. In that case, you’re likely better off waiting until you hit the one-year mark to sell (assuming you want to sell the investment) rather than selling before the one-year mark. That way, you’ll pay long-term as opposed to short-term.
What are the Tax Rates for Short-Term capital gains versus Long-term Capital Gains?
As stated in the example above, reaching the one-year holding period can be advantageous to pay long-term capital gains instead of short-term. Short-term capital gains are paid at a higher tax bracket than long-term. Therefore, the after-tax return of your investment is greater when you pay long-term versus short. See the schedules below, outlining the 2022 ordinary income (the rates that short-term capital gains are paid at) and long-term capital gains rates. As you can see, if an individual making $150,000 per year were to sell an investment with a $10,000 short-term capital gain, they would pay at the marginal tax rate of 24%. However, if they held the investment for more than one year, they would only be subject to a 15% long-term capital gain rate. The difference would save around $900 in taxes.
What if my investment has a loss, and I sell it?
Investments don’t always appreciate, unfortunately. However, there is a silver lining when selling investments at a loss. Again, let’s use an example of a $10,000 capital loss on an investment. The investor decides to sell when then “realizes” the $10,000 loss for tax purposes. The investor has no other losses on the year and has another $5,000 that was “realized” (the investment was sold) in capital gains. When reporting taxes, the investor can offset the $5,000 capital gain with $5,000 in losses, meaning no taxes are owed on the capital gain. Secondly, the investor can use up to $3,000 to offset ordinary income. The remaining $2,000 losses will be carried over into the new tax year to offset future capital gains.
The ability to carry over capital losses indefinitely can be a valuable tool for investors as they manage their portfolios. We call this strategy “tax-loss harvesting”, which, with careful tax planning, can enhance after-tax returns over the long-term.
What types of accounts have to pay capital gains?
Not all investment accounts have to worry about capital gains taxes. For example, tax advantageous accounts such as 401(k)’s, 403(b)’s, IRA’s and Roth IRA’s all don’t have to worry about capital gains taxes. This is one of the primary benefits of these types of accounts since the gains on particular investments may become very large over many years. It’s also why some investors may prefer to weigh their more “risky” yet higher growth potential investments within their retirement accounts, knowing that the ability to buy/sell without worrying about capital gains is a huge advantage.
The accounts that have to pay capital gains are ordinary brokerage accounts. Sometimes referred to as taxable accounts. The same types of investments may be purchased as in retirement accounts, but capital gains are realized whenever an investment is sold. Keep in mind this also refers to employee stock purchase plan accounts, RSU accounts, and accounts that hold exercised stock options. Ensure you understand the tax consequences when selling investments in these accounts.
How do Capital gains affect real estate?
Generally, capital gains apply the same way to real estate as it does to stocks and bonds. However, there is one major difference. For primary residences, if you live in the home for at least two of the past five years, you can exclude up to $250,000 of capital gains for an individual or $500,000 for married filers. This is a HUGE advantage for homeowners who eventually sell their primary residence. For example, if you bought your home for $700,000, lived in it for three years, and sold it the year you moved out for $1,000,000, you’ll only owe capital gains taxes on $50,000 of the $300,000 total gain if a single filer and zero capital gains taxes if married filing jointly!
One pitfall homeowners can potentially fall into is when they rent their former primary residence. It’s often financially more beneficial to sell the home (assuming it has large capital gains) to lock in attractive “after-tax” returns that may not include any capital gains owed. The key is to sell within that two out of the past five years window. Otherwise, you lose the exemption. A financial planner can run these scenarios to help you determine whether renting or selling is the best option for you in cases where renting may seem attractive and assuming you don’t need the capital from the prior home to purchase a new home.
Finally, when it comes to investment properties the owner has never lived in, the capital gains rules apply just as they do for stocks and bonds. In most cases, owners who purchase investment properties will plan to hold the property long-term, so only long-term capital gains may need to be calculated. With the caveat that depreciation is subtracted from the cost basis at which the home was purchased. That’s another tax story that we won’t dive into here. Investors that “flip” homes may still need to pay short-term capital gains assuming they sell the home before owning it for one year.
The Bottom Line
Capital gain taxes are relatively straightforward. A basic understanding of short-term versus long-term and the primary home exemption can help navigate potential tax questions when selling investments or real estate. Remember, careful planning will help you navigate taxes better than making decisions on a whim. If you need assistance reviewing capital gains, tax planning, or investments, schedule a free consultation today!