A capital gain occurs when you sell something for more than you spent to acquire it. This happens a lot with investments, but it applies to personal property, too. Buy a used car for $3,000 and sell it for $5,000 a week later, and you have a $2,000 capital gain - same as if you bought stock for $3,000 and sold it for $5,000. Every taxpayer should understand a few basic facts about capital gains taxes.
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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 the case whether you bought it as an investment, such as stocks or property, or for personal use, such as a car or a big-screen TV.
If you sell something for more than your "basis" in the item, then the difference is a capital gain, and you’ll need to report that gain on your taxes. Your 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
In addition, money spent on improvements that increase the value of the asset -- such as a new addition to a building -- can be added to your basis. Depreciation of an asset can reduce your basis.
In most cases, your home is exempt
The single biggest asset many people have is their home, and depending on the real estate market, a homeowner might realize a huge capital gain on a sale. The good news is that the tax code allows you to exclude some or all of such a gain from capital gains tax, as long as you meet three conditions:
- You owned the home for a total of at least two years in the five-year period before the sale.
- You used the home as your primary residence for a total of at least two years in that same five-year period.
- You haven't excluded the gain from another home sale in the two-year period before the sale.
If you meet these conditions, you can exclude up to $250,000 of your gain if you're single, $500,000 if you're married filing jointly.
Length of ownership matters
If you sell an asset after owning it for more than a year, any gain you have is a "long-term" capital gain. If you sell an asset you've owned for a year or less, though, it's a "short-term" capital gain. And the tax bite from short-term gains is significantly larger than that from long-term gains.
"You pay a higher capital gains tax rate on investments you've held for less than a year, often 10 to 20 percent more, and sometimes even higher," says Matt Becker, a financial planner and founder of Mom and Dad Money, LLC. That difference in tax treatment, Becker says, 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.
Also, Becker notes that 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 something for less than its basis, you have a capital loss. Capital losses from investments -- but not from the sale of personal property -- can be used to offset capital gains. So if you have $50,000 in long-term gains from the sale of one stock, for example, but $20,000 in long-term losses from the sale of another, then you may only be taxed on $30,000 worth of 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, the excess can be carried forward to future years to offset income in those years.
Business income isn't a capital gain
If you operate a business that buys and sells items, your gains from such sales will be considered -- and taxed as -- business income rather than capital gains. For example, many people buy items at antique stores and garage sales and then resell them 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 and the difference between them is treated as income, subject to the same taxes as income from employment.