5 Things to Know About Capital Gains Tax
Benjamin Franklin once said, “In this world, nothing is certain except death and taxes.” Pretty morbid, I know. Though paying taxes always seems inevitable, there are ways you can reduce your tax burden. Accordingly, Franklin also said, “Look before, or you’ll find yourself behind.” So, take his advice, and read on to learn 5 things about capital gains tax and how to reduce it.
1. Nearly everyone is subject to pay capital gains tax
Anyone who owns a capital asset can be subject to a capital gains tax, and a capital asset doesn’t just include investments. You could incur a capital gains tax on your car, electronics, jewelry, real estate, land, business holdings…you get the idea.
The amount in tax that you may be subject to is the amount that you sold an asset for minus what you paid for it. For example, if you buy ABC stock for $100 per share, and it grows to $150 per share, when you sell it, you will need to pay capital gains tax on the $50 per share in gains.
Certain things can be added to the amount you paid for the asset, or the “basis.” Consider a rental property purchase, for example. Let’s say you purchase an old home for $100,000, and you invest another $50,000 to renovate it and add an additional bathroom. Your “basis” in the home—or the total amount you paid for it, for tax purposes—is actually $150,000. So, if you turn around and sell the home for $225,000, you will only be taxed on the $75,000 in gains, which is the amount you sold it for minus the original purchase price and the investment for improvements.
2. Your home is usually exempt
Though rental properties typically trigger a capital gains tax, primary residences don’t, under certain conditions. This is great news, as our home might be one of the most valuable assets we’ll ever own.
The IRS allows you to exclude some or all of the gain you’ve realized in your home, if all three of the following conditions are met:
You have owned the home for a total of at least two years in the five-year period before the sale
You actually lived in 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 these are all true in your case, you can exclude up to $250,000 of your gain if you're single and $500,000 if you're married filing jointly.
3. How long you own something matters
There are two types of capital gains: long term and short term. A long-term capital gain applies to assets you’ve owned for longer than one year, while a short-term capital gain applies to assets you’ve owned for less than one year.
Short-term capital gain rates are significantly higher than long-term capital gains rates. Why the differentiation? Among several reasons, the IRS wants to encourage investors to adopt a “buy-and-hold” strategy for the long term.
Keep in mind, people in the lowest tax brackets usually do not have to pay any long-term capital gains taxes. So, if your income is in this range during a specific tax year, you may benefit from selling assets at a gain during this year to avoid a big tax bill.
4. You can offset gains with losses
Here’s where the fun begins. Within your taxable investment portfolio (think: Brokerage Account, not your IRA or 401k), you can offset investment losses with investment gains to reduce your capital gains exposure. This is referred to as “tax loss harvesting.”
If you sell an investment with a $10,000 loss, and your overall portfolio otherwise grows by $10,000 during the year, you would not pay any capital gains tax on your investment portfolio for that specific year.
If your portfolio losses exceed your 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 excess capital losses, the amount over $3,000 can be carried forward to future years to offset capital gains or income in those years.
Read more about tax loss harvesting here.
5. Come up with your own capital gains strategy
The first question to ask (yourself or your advisor) is, “How can I reduce my capital gains tax?” You should start by assessing all of your capital assets, the associated growth and how long you’ve owned them. You’ll want to understand your capital gains tax exposure and how much is short term vs. long term.
Next, make lemonade out of lemons! Within your taxable portfolio—outside of retirement accounts—consider selling investments at a loss, and then repurchasing them to maintain portfolio diversification. Be careful of the wash-sale rule, which states that you must wait 30 days to buy back into the same security. You can offset this loss against your income or portfolio gains to reduce your tax bill.
Also, look forward into future years and estimate whether or not your income might change drastically. I know that no one has a crystal ball, but if you anticipate that your income will fall in future years, which is fairly common among those transitioning into retirement, then it may be in your best interest to wait to sell assets at a gain to reduce or avoid a capital gains tax.
If you want to learn about how to reduce your capital gains tax burden, reach out to me at Ben@coveplanning.com or schedule a free consultation call.
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Ben Smith is a fee-only financial advisor and CERTIFIED FINANCIAL PLANNER™ (CFP®) Professional with offices in Milwaukee, WI, Evanston, IL and Minneapolis, MN, serving clients virtually across the country. Cove Financial Planning provides comprehensive financial planning and investment management services to individuals and families, regardless of location, with a focus on Socially Responsible Investing (SRI).
Ben acts as a fiduciary for his clients. He does not sell financial products or take commissions. Simply put, he sits on your side of the table and always works in your best interest. Learn more how we can help you Do Well While Doing Good!
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Ben Smith, and all rights are reserved. Read the full Disclaimer.