What Are Capital Gains and How Are They Taxed?
April 22, 2022
A capital gain is simply any increase in the value of a capital asset (cars, houses, stocks, bonds, mutual funds / exchange traded funds, farm ground, other investment real estate, art, etc.). You’ve probably noticed the increase in home values lately and if you own your home and it’s worth more now than you paid for it, then you have experienced a capital gain. The same goes for your investment portfolio (hopefully!). Over time the value of your account goes up and the increase in value is referred to as a capital gain.
EXAMPLE: John buys a lot he intends to build a house on for $30,000.00. John changes his mind after purchasing the lot and just holds on to it. Later, the lot is now worth $50,000.00. John owns a lot worth $20,000.00 more than he paid for it. John has experienced the appreciation of a capital asset and now has a capital gain of $20,000.00.
Capital losses work the same way, but in reverse. If a capital asset you purchased loses value, then you experience a capital loss.
This is where things start to get interesting. Even though some lawmakers are introducing nightmarish capital gains (a.k.a. “wealth”) taxes on gains like John in the above example experienced, it does not yet work that way. Just because the value of an asset you own appreciates that doesn’t automatically mean you’re taxed on the gain. In fact, just holding on to an asset while it appreciates all the way until you die is usually a good way to make sure you don’t pay any taxes on it. The IRS generally doesn’t get involved until a capital gain (or loss) is realized. 1 You realize a capital gain or loss when you sell a capital asset.
Once you sell it’s time to start deciding if you’ve got some deductible losses or reportable gains! FYI: personal use property losses (e.g. losses from the sale of your personal home or vehicle) are usually not deductible. However, capital gains realized from the sale of your vehicle and your home (there is an exemption for your house up to a limit though!) are reportable and taxed as income. Thanks IRS, that sounds about right.
The first step to figuring out how your losses or gains will be taxed is to find out if they are classified as short-term or long-term. Count from the day after you got the asset through the last day that you owned it. If that equals one year or less then it’s a short-term holding period. If it’s more than one year then it’s a long-term gain. There it is!
EXAMPLE: John decides to sell his unimproved property for $50,000.00 for a $20,000.00 profit. He bought the property on January 1, 2021 and sold it on January 2, 2022. The $20,000 gain is classified as a long-term capital gain.
EXAMPLE: John sells the property on December 31st 2021 for the same $20,000.00 profit. The gain is classified as a short-term capital gain.
This seems like splitting hairs but it can be very important to understand the difference between realized and recognized gains especially when you’re trading assets for other assets. Realized gains are the “profit”. A realized gain is the difference between the net sales price and the adjusted tax basis on the property. A recognized gain is the taxable part of the realized gain.
The difference could come in to play if you were to sell a piece of farm ground to someone else and they paid you in farm ground and cash. The cash would be considered “boot” since it’s a non-like property received in an exchange. Boot is taxed as a capital gain (Yes. Boot. Imagine a farmer agreeing to a trade and having to pull cash out of his boot to make up the difference in value. That’s how I remember it and how tons of 400 level tax professors teach it)
EXAMPLE: John has a friend, Dave, who has another lot that John would like to build on instead of the lot he bought. Dave offers to swap lots, but his property is valued at $40,000. John and Dave use a section 1031 exchange and Dave gives John $10,000 and his lot in exchange for John’s lot. John has a recognized gain of $10,000.00 of “boot”.
Often times, especially with investments like stocks, bonds, and funds recognized gains and realized gains are identical.
Net short-term gains (short-term gains minus short-term losses) for the year are taxed at your ordinary income tax rates. Those are generally much higher than the preferential tax-rates that long-term gains receive.
EXAMPLE: John has a $20,000.00 short-term gain from the sale of his unimproved property in 2021. He also had a short-term loss from the sale of some exchange traded funds he had in a non-qualified brokerage account of $10,000.00. John’s net short-term gains for 2021 were $10,000.00. Since John made over $300,000 from his job and files Married Filing Joint the $10,000.00 gain is taxed at 32% resulting in $3,200.00 of additional tax liability.
Net long-term gains are the total long-term capital gains minus and long-term capital losses less any unused carryover capital losses. Net capital gains are net long-term gains minus net short-term gains. Net capital losses (if your capital losses are more than your gains in the tax year) can be deducted up to $3000.00 a year if married filing joint. Net capital gains are taxed at a special tax rate table that is determined by your income.
|Tax-filing status||Single||Married, filing jointly||Married, filing separately||Head of household|
|0%||$0 to $40,400||$0 to $80,800||$0 to $40,400||$0 to $54,100|
|15%||$40,401 to $445,850||$80,801 to $501,600||$40,401 to $250,800||$54,101 to $473,750|
|20%||$445,851 or more||$501,601 or more||$250,801 or more||$473,751 or more|
EXAMPLE: John has a $20,000.00 long-term gain from the sale of his unimproved property in 2021. He also had a short-term loss from the sale of some exchange traded funds he had in a non-qualified brokerage account of $10,000.00. John’s net long-term gains for 2021 were $10,000.00. John’s tax liability for the $10,000 is $1,500. A $1,700 savings from the scenario where he realized a short-term gain on the property.
There are other variables that come in to play when capital gains and losses are concerned such as depreciation, adjusted basis, and more. It’s very important to work with a qualified tax professional when working on your taxes and to help you make a plan to minimize your overall tax bill over your lifetime.