5 Things You Should Know about Capital Gains Tax
When you sell something at a profit, the IRS generally requires you to pay capital gains tax. Capital gains taxes can apply to various types of investments, including stocks, vehicles, and some real estate. However, you may qualify for a capital gains tax exemption. Here are some key things you should know about capital gains taxes.
Key Takeaways
- Capital gains tax may apply to any asset you sell, whether it is an investment or something for personal use.
- If you sell something for more than your "cost basis" of the item, then the difference is a capital gain, and you’ll need to report that gain on your taxes.
- Depending on the real estate market, you might realize a huge capital gain on a sale of your home. The tax code lets you exclude some or all of such a gain from capital gains tax. But, you must meet certain requirements.
- How your gain is taxed depends on how long you've owned the asset before selling. Short-term gains are usually taxed at a higher rate than long-term gains.
Capital gains aren't just for rich people
Anyone who sells a capital asset should know that capital gains tax may apply. And as the Internal Revenue Service points out, just about everything you own qualifies as a capital asset. That's true if you bought it as an investment, like stocks or property. It's also true if you bought it for personal use, like a car or a big-screen TV.
If you sell something for more than you paid for it, the extra money is called a capital gain. You need to report your capital gains on your taxes.
Your cost basis is usually what you paid for the item. It includes not only the price of the item, but any other costs you had to pay to acquire it, including:
- sales taxes, excise taxes and other taxes and fees
- shipping and handling costs
- installation and setup charges
Also, money spent on improvements raises the asset's value. For example, a new building addition can be added to your cost basis. Depreciation of an asset can reduce your cost basis.
In most cases, your home has an exemption
Many people's biggest asset is their home. Depending on the real estate market, a homeowner might make a huge gain on a sale. The good news is that the tax code lets you exclude some or all of such a gain from capital gains tax. You can do this if you meet all three conditions:
- You owned the home for a total of at least two years.
- You used the home as your primary residence for a total of at least two years in the last five-years before the sale.
- You haven't excluded the gain from another home sale in the two-year period before the sale.
You can exclude up to $250,000 of your gain. You can do this if you meet these conditions and file as Single, Head of Household, or Married Filing Separately. If you file Married Filing Jointly, you can exclude up to $500,000.
TurboTax Tip:
If capital losses exceed capital gains, you may be able to use the loss to offset up to $3,000 of other income for the tax year and carry the excess over to future years.
Length of ownership matters
If you sell an asset after owning it for more than a year, any gain you have is typically a "long-term" capital gain. If you sell an asset you've owned for a year or less, though, it's typically a "short-term" capital gain. How your gain is taxed depends on how long you owned the asset before selling.
- The tax on short-term gains is larger than on long-term gains. It can be 10-20% higher.
- This difference in tax treatment is one of the advantages a "buy-and-hold" investment strategy has over a strategy that involves frequent buying and selling, as in day trading.
- People in the lowest tax brackets usually don't have to pay any tax on long-term capital gains. The difference between short and long term, then, can literally be the difference between taxes and no taxes.
Capital losses can offset capital gains
As anyone with much investment experience can tell you, things don't always go up in value. They go down, too. If you sell an investment asset for less than its cost basis, you have a capital loss. Typically you can use capital losses from investments to offset capital gains. But, you can't use them to offset gains from selling personal property. For example
For example:
- You made $50,000 in long-term gains by selling one stock. But, you lost $20,000 from selling another. So, you may only be taxed on $30,000 of long-term gains.
- $50,000 - $20,000 = $30,000 long-term capital gains
If capital losses exceed capital gains, you may be able to use the loss to offset up to $3,000 of other income. If you have more than $3,000 in capital losses, this excess amount can be carried forward to future years to similarly offset capital gains or other income in those years.
Business income isn't a capital gain
If you run a business that buys and sells items, your gains from such sales will be business income. They will be taxed as business income, not capital gains.
Many people scour antique stores and garage sales for hidden gems to resell in online auctions. Do this in a businesslike manner and with the intention of making a profit, and the IRS will view it as a business.
- The money you pay out for items is a business expense.
- The money you receive is business revenue.
- The difference between them is business income, subject to self-employment taxes.
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