Capital Gains Tax

When you sell an asset for more than you paid for it, you trigger what is called a capital gains tax. In the same way Uncle Sam wants a part of your income in the form of federal and state tax, the government also wants a piece of your profit on other winning investments. How much you pay depends in part on how long you hold onto that capital asset.
There are ways you can reduce or sometimes avoid these taxes altogether. Holding onto that investment for a year or more means profits count as long-term capital gains, which are taxed at a lower rate than short-term capital gains. You can also put your money in tax-advantaged retirement plans, or you can offset those capital gains with capital losses.

Investments like stocks, bonds, real estate, cars, and other material items can trigger capital gains taxes. Any money you earn on the sale price of these investments is known as your capital gain. Think of the simple equation this way: selling price minus purchase price equals capital gain.

On the flip side, if you lose money on these, that’s your capital loss—and you can use capital losses to offset any gains for tax purposes. 

Let’s say you bought and sold some property this tax year. On one of those investments, you made $250,000. On another, you lost $100,000. So, you’ll need to pay tax on your capital gains of $150,000. That number represents your net capital gain.

Now, if you lost more than you made when you sold those properties, you can deduct the difference on your tax return—capped at $3,000.
To determine what tax rate applies to the capital gain, include it in your income. Note that capital gains taxes are progressive.

The IRS generally allows you to exclude $250,000 of real estate capital gains if you’re single. For married couples with joint filing status, this number doubles to $500,000. 

Let’s say you purchased a home 15 years ago for $100,000 and sold it today for $600,000; you’d make $500,000 on that sale. The entire amount of that $500,000 gain could be excluded from capital gains tax for married couples filing jointly. 

However, note that many factors require you to actually pay tax on the whole gain. These include cases when: 

As we noted above, you can get a lower tax rate if you hang onto your capital asset for a year or longer. And you should do that if you can, because the long-term capital gains tax rate is substantially lower than the short-term capital gains rate for most assets.

Short-term capital gains are taxed the same way as regular income for tax brackets up to 37 percent. That’s steep compared with long-term capital gains, which are taxed much more favorably at rates that can be as low as zero percent, depending on your income. 

For 2020, the capital gains tax rates are either zero percent, 15 percent, or 20 percent for most assets you hang on to for a year or more. Federal tax rates on most assets you hold for less than a year fall into ordinary income tax rates: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, or 37 percent. 

You can defer (although not avoid) taxes on real estate held as an investment through a 1031 exchange. This way, investors can sell property without paying capital gains taxes on the sale, as long as the equity is applied to a “like-kind” purchase. In this way, your taxes are not forgiven—again, they are just deferred—but this is a powerful way for investors to reinvest real estate equity multiple times without paying taxes on those gains. The tax savings is a way to help build wealth faster; by its very nature, the 1031 exchange encourages reinvestment. 

So investors can put their investment income back into bigger or more desirable real estate, diversify their portfolios, and also restart the timer on the real estate depreciation income tax deduction.

Let’s consider an example of how that works in a real-world real estate investing scenario. Let’s say you bought a starter home five years ago for $200,000 and put $20,000 down. You used it as a rental property for the past three years. Over the course of the time you owned that property, it appreciated to $305,000 in value. If you sold it now and walked away with the profit, you’d owe capital gains taxes of 15 to 20 percent. But instead, you can leverage the tax advantages of the 1031 exchange by reinvesting your money, deferring the tax, and investing the entire profit. You’ll only pay taxes on any portion you didn’t reinvest. 

So what constitutes a like-kind property that qualifies for a 1031 exchange? The good news is that term is pretty broad, and most types of real estate are actually considered to be like-kind. So yes, a single-family residence is indeed considered like-kind to a vacant piece of land, a five-unit apartment building, or even a commercial property. 

Note that property should be within the United States; a U.S. investment is not considered like-kind to an international one. As well, any property you purchase using a 1031 exchange must be held for investment; you can’t use it for resale or personal use, usually for a minimum of two years after escrow closes.

Inherited property qualifies for that long-term capital gains tax rate. As well, inherited property receives a “stepped-up” basis back to the date of the death of the person who passed the property to you.

Let’s say you inherit a home valued at $500,000 on the date of that person’s death. You hold it for a few years and then sell it for $600,000. You would then owe long-term capital gains tax on $100,000. 

And you’d owe on that $100,000 figure even if the person who bought the property originally did so for only $250,000. You don’t have to use the original number in your calculation: Instead, your figure is stepped up to the value of the property when the person died. Of course, this typically means your taxable income is much less than it would have been if you were the purchaser at that original $250,000 sale price. 

If you do end up selling an inherited home for less than its stepped-up basis, you can deduct that capital loss, as long as you’re not using that property as your own residence. But note that only $3,000 of those losses can be deducted against your ordinary income per year. You have to carry over any excess into future years to be deducted then. 

A note here too about 1031 exchanges and inheritance: An investor who continues to reinvest using the 1031 exchange passes that advantage onto heirs. Upon inheritance, those deferred taxes are wiped out. Inherited property that was gotten through a 1031 exchange transfers to the heirs at the stepped-up market-rate value, and at that time all deferred taxes are forgiven. 

There is in fact a way to get that coveted zero percent tax rate on long-term capital gains. “Harvesting” capital gains means selling an investment that you know will have a long-term capital gain in years when you will not be taxed on that gain. And that happens when it falls in a year where you are in the zero percent capital gains tax bracket.

This 0 percent tax rate on capital gains applies to married couples with taxable income as high as $78,750, and single filers with taxable income up to $39,375.

In normal years, your taxable income might be much higher than that figure—so the strategy wouldn’t apply. But there are some years when you’re in lower income tax situations. Sometimes you can even force this situation, such as after retirement when you can choose which accounts from which to make withdrawals each year. You might also find those tax-free opportunities if you find yourself temporarily unemployed, or if your income varies dramatically from year to year, as with sales commissions, for example.

Investors should be aware of the net investment income tax: In some cases, you may owe an additional 3.8 percent tax that applies to the smaller amount of either your net investment income or the amount by which your modified adjusted gross income exceeds amounts in certain categories.

You might be subject to an additional tax if your income threshold is $200,000 for single or head of household filers, $250,000 for married couples filing jointly, or $125,000 for married couples filing separate tax returns.

Also note that any earnings on your individual retirement account (IRA) won’t get the lower capital gains tax treatment. These are taxed at the same rate as your income.