If you plan to purchase (or have already purchased) and sell a property, it’s expected that you will have to deal with the capital gains tax on some level. By acquainting yourself with the capital gains tax in advance, you can save yourself time, tension, and money when the time comes to sell.
The article will explore capital gains tax in-depth, including how to calculate capital gains tax, how to minimize the amount you pay, short-term capital gains tax, and more.
Table of Contents
- 1 What is a Capital Gains Tax?
- 2 How do you Calculate Capital Gains Tax?
- 3 Short Term Capital Gains Tax
- 4 2020 Capital Gains Tax Brackets
- 5 Capital Gains Taxes on Property
- 6 Capital Gains Tax On Small Business Stock
- 7 Capital Gains Tax Calculator
- 8 Five Ways to Minimize or Avoid Capital Gains Tax
What is a Capital Gains Tax?
A capital gains tax is a tax on the increase in the value of investments incurred when individuals and corporations sell those investments. When the assets are sold, the capital gains are described as having been “realized.” The tax is not applicable to unsold investments or “unrealized capital gains,” so stock shares that increase every year will have to pay capital gains taxes until they are sold, no matter how long you plan to hold them.
The U.S. capital gains tax is only appliable to profits from the sale of assets held for more than a year, referred to as “long term capital gains.” The rates are 0%, 15%, or 20%, based on the tax bracket. Short-term capital gains tax applies to assets held for a year or less, and are taxed as ordinary income.
Taxable capital gains for the year are lowered by the number of capital losses incurred in that year. A capital loss occurs when you sell an investment for less than you bought it for. The total of long-term capital gains minus any capital losses is known as the “net capital gain,” which is the amount capital gains taxes are evaluated on.
How do you Calculate Capital Gains Tax?
The first step when calculating your capital gains tax is always defining your cost base. This is the amount you paid for the asset, as well as costs incurred in buying and selling it and incidental expenses, which may comprise:
Otherwise known as capital cost, these may consist of:
- Costs of transfer
- Stamp duty
- Borrowing expenses, such as loan application or mortgage discharge fee
- Advertising costs to find a buyer, seller, or tenant
- Valuation and termination fees
- Professional services such as conveyancers, brokers, agents, or accountants
Once you have defined your cost base, there are two methods you can make use of to calculate your capital gains tax – the discount and indexation methods. In most situations, you can choose to use the strategy that results in the lowest capital gains tax.
How to Calculate Capital Gains Tax using the Discount Method?
There are four steps to follow when using the discount method to calculate your capital gains tax.
- Deduct the cost base from the sale proceeds to calculate gross capital gain.
- Subtract any qualified capital costs.
- Apply any appropriate discounts.
- The figure you will get is your net capital gain and will be added to your taxable income.
How to Calculate Capital Gains Tax using the Indexation Method?
You know how your parents used to tell, “back in my day, that would have only cost me a penny!”? Well, the indexation method is based on similar logic.
It’s calculated by dividing the consumer price index (CPI) at the time you sold your property by the CPI at the time you bought the property, rounded to three decimal places. You would then add that number to your initial cost price to find your inflation-adjusted purchase price, then subtract that amount from your sale price.
|Less than 12-months|
|Property ownership is less than 12-months from the date of purchase.||The most basic method of Capital Gains Tax (CGT)||Sale price less cost.|
|Property ownership is greater than 12-months from the date of property purchase ownership costs.||A 50% discount applies to property purchased after September 21, 1999, for individuals and 33.3% for super funds.||The purchase price + sales price = net gain – any ownership costs.|
|Property ownership began after September 20, 1985, but before 11.45am (ACT time) September 21, 1999.||The cost base increases by applying an indexation factor based on Consumer Price Index (CPI).||marginal tax rate x indexation factor x capital gain.
An Example Of How To Calculate Capital Gains Tax
Assume you purchased 100 shares of ABC stock at $20 per share and sold them more than a year later for $50 per share. Let’s also say that you fall into the income category (see “What You’ll Owe,” below) where your long-term gains are taxed at 15%. The table below recapitulates how your gains from ABC stock are affected.
|Bought 100 shares @ $20||$2,000|
|Sold 100 shares @ $50||$5,000|
|Capital gain taxed @ 15%||$450|
|Profit after tax||$2,550|
In this example, $450 of your profit will go to the government. But it could be awful. Had you held the stock for one year or less (making your capital gain a short-term one), your profit would have been taxed at your ordinary income tax rate, which can be as high as 37%. And that’s not counting any additional state taxes.
Short Term Capital Gains Tax
The gain or profit from the sale of assets is categorized as a capital gain. The tax for this capital gain needs to be paid in the year that the asset transfer takes place. So, what is Short Term Capital Gains Tax? Short Term Capital Gains Tax is the tax imposed on profits generated from the sale of an asset which is held for a government-specified short period is called short-term capital gains tax. The short term period differs for different items.
How is Short Term Capital Gains Calculated?
After taking the full value of the asset into account, subtract the expenditures incurred in
connection with the transfer. Additionally, subtract the cost of acquisition and improvement costs. The leftover amount is a short-term capital gain, which will then be taxed under STCG.
What is Short Term Capital Gains Tax rate?
Once the period of holding for a variety of assets is specified to be categorized as “short term,”
one has to look at the tax rates that are applicable. For example, the government may choose to apply 15%* short term capital gains tax when securities transaction tax is applicable. Likewise, when securities transaction tax is not applicable, the short-term capital gain is added to the income tax return, and the taxpayer is taxed according to their income tax slab.
2020 Capital Gains Tax Brackets
Below are the 2020 capital gains tax rates.
The actual rates didn’t change for 2020, but the income brackets did adjust somewhat.
Short-Term Capital Gains Rates 2020
Tax rates for short-term gains are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Short-term gains are for assets held for one year or less – this consist of short term stock holdings and short term collectibles.
|2020 Short Term Capital Gains Tax Brackets|
|Tax Bracket/Rate||Single||Married Filing Jointly||Head of Household|
|10%||$0 – $9,875||$0 – $19,750||$0 – $14,100|
|12%||$9,876 – $40,125||$19,751 – $80,250||$14,101 – $53,700|
|22%||$40,126 – $85,525||$80,251 – $171,050||$53,701 – $85,500|
|24%||$85,526 – $163,300||$171,051 – $326,600||$85,501 – $163,300|
|32%||$163,301 – $207,350||$326,601 – $414,700||$163,301 – $207,350|
|35%||$207,351 – $518,400||$414,701 – $622,050||$207,351 – $518,400|
Long-Term Capital Gains Rates 2020
Similar to short-term gains, there are four filing categories: single, married and filing jointly, head of household, and married and filing separately. The amount of taxes paid is dependent on income.
The brackets adjusted slightly upwards for 2020.
Long-term gains are those on assets held for over a year. Below, the percentage of taxes paid are listed on the left with the corresponding income on the right.
|2020 Long Term Capital Gains Tax Brackets|
|Tax Bracket/Rate||Single||Married Filing Jointly||Head of Household|
|0%||$0 – $40,000||$0 – $80,000||$0 – $53,600|
|15%||$40,001 – $441,450||$80,001 – $496,600||$53,601 – $469,050|
Capital Gains Taxes on Property
If you are the owner of a home, you may be pondering how the government taxes profits from home sales. As with other assets such as stocks, capital gains on a home are equal to the difference between the sale price and the seller’s basis.
Your basis in your home is what you paid for it, plus closing costs and non-decorative investments you made in the property, like a new roof. You can also add sales expenditures like
real estate agent fees to your basis. Deduct that from the sale price and you will get the capital gains. When you sell your primary residence, $250,000 of capital gains (or $500,000 for a couple) are excused from capital gains taxation. This is normally true only if you have owned and utilized your home as your main residence for at least two out of the five years before the sale.
If you inherit a home, you will not be applicable for the $250,000 exemption unless you’ve owned the house for at least two years as your primary residence. But you can still get a
break if you don’t fulfill that criteria. When you inherit a home you receive a “step up in basis.”
Suppose your mother’s basis in the family home was $200,000. Today the market value of the home is $300,000. If your mom transfers the ownership of the home to you, you’ll automatically be eligible for stepped-up basis equal to the market value of $300,000. If you sell the home for that amount then you are not liable to pay capital gains taxes. If you later sell the home for $350,000 you only pay capital gains taxes on the $50,000 difference between the sale price and your stepped-up basis. If you’ve owned it for more than two years and utilized it as your primary residence, you wouldn’t have to pay any capital gains taxes on property.
Isn’t that good? Stepped-up basis is a bit controversial and might not be around always. As always, the more significant your family’s estate, the more it pays to seek advice from a
professional tax adviser who can work with you on lowering taxes if that’s your aim.
Capital Gains Tax On Small Business Stock
The sale of qualified small business stock (QSBS) is regarded positively for capital gains purposes. Under Section 1202 of the Internal Revenue Code—the Small Business Stock Gains Exclusion—the capital gains from qualified small businesses are exempted from federal taxes.
The tax treatment of a qualified small business stock is based on when the stock was purchased and how long it was held. In order to be eligible for this exemption, the stock must have been purchased from a qualified small business after Aug. 10, 1993, and the investor must have held the stock for at least five years. This omission has a cap of $10 million, or 10 times the adjusted basis of the stock—whichever is greater. Any capital gains beyond that amount are subject to a 28% rate.
Capital Gains Tax Calculator
Most people calculate their tax (or have professionals do it for them) using software that automatically makes the calculations. But if you want to know of what you may pay on a prospective or actualized sale, you can make use of a capital gains tax calculator to get a rough idea. Numerous free ones are accessible online.
Five Ways to Minimize or Avoid Capital Gains Tax
There are several things you can do to reduce or even escape capital gains taxes:
- Invest for the long term.
If you are able to find great companies and hold their stock for the long term, you will pay the lowest possible rate of capital gains tax. Of course, this is easier said than done. A company’s fortunes can vary over the years, and there are numerous reasons you might want or need to sell earlier than you originally predicted.
- Take advantage of tax-deferred retirement plans.
When you invest your money through a retirement plan, such as a 401(k), 403(b), or IRA, it will increase without being exposed to immediate taxes. You can also purchase and sell investments within your retirement account without causing the need to pay capital gains tax.
In the case of traditional retirement accounts, your gains will be taxed as ordinary income
when you withdraw money, but by then you may be in a lower tax bracket than when you were working. With both accounts, nevertheless, the money you withdraw will be tax-free, as long as you abide by relevant rules.
For investments outside of these accounts, it might be incumbent upon investors who are near retirement to wait until they actually stop working to sell. If their retirement income is low enough, their capital gains tax bill might be lowered, or they may be able to escape from paying any capital gains tax. But if they’re already in one of the “no-pay” brackets, there’s a key factor to remember: If the capital gain is large enough, it could increase their income to a level where
they’d incur a tax bill on their gains.
You can use capital losses to offset your capital gains as well as a portion of your regular income. Any amount that’s left over after that can be carried over to future years.
- Use capital losses to offset gains.
If you face an investment loss, you can take benefit from it by lowering the tax on your gains on other investments. Suppose you own two stocks, one of which is worth 10% more than you paid for it, while the other is worth 5% less. If you sold both stocks, the loss on the one would lower the capital gains tax you’d owe on the other. Apparently, in an ideal situation, all of your investments would increase, but losses do occur, and this is one way to get some value from them.
If you have a capital loss that’s greater than your capital gain, you can use up to $3,000 of it to make up for ordinary income for the year. After that, you can carry over the loss to future tax years until it is exhausted.
- Watch your holding periods.
If you are selling a security that you purchased about a year ago, make sure to find out the trade
date of the purchase. Waiting a few days or weeks in order to be eligible for long-term capital gains treatment might be a sensible move as long as the price of the investment is holding comparatively constant.
- Pick your cost basis.
When you’ve bought shares in the same company or mutual fund at different times and at different prices, you’ll need to ascertain your cost basis for the shares you sell. Even though investors usually use the first in, first out (FIFO) method to determine cost basis, there are four other methods available: last in, first out (LIFO), dollar value LIFO, average cost (only for mutual fund shares), and specific share identification.
If you’re selling a substantial holding, it could be worth discussing with a tax advisor to decide
which method makes the most sense.
Lastly, it’s crucial to take taxes into account as part of your investing strategy. Decreasing the capital gains taxes you have to pay, such as by holding investments for over a year before you sell them, is one simple way to improve your after-tax returns.