Billionaire business owner Warren Buffett once famously commented that his secretary paid taxes at a higher rate than he did. Although there are surely many factors at play – among them Buffett’s intentionally low salary and his large charitable donations – a big part of the story is that Buffett earns a relatively large share of his income from capital gains.
Income in the form of capital gains has historically been taxed at substantially lower rates than ordinary income like wages, tips, unemployment compensation, gambling winnings, and the like. That’s because capital investments are generally viewed by policymakers as engines of growth that stimulate the economy. The lower tax rates are designed to encourage this beneficial activity. And it’s not just the buying and selling of stocks and bonds that receive favorable capital gain treatment. The lower capital gains tax rates apply to profits from other types of investments as well, like the capital gain from the sale of real estate (including your home) or even a small business.
Since the capital gains tax applies to so many types of investment transactions, it’s an important piece of the overall tax picture for millions of Americans. But most people don’t know much about the capital gains tax – or certainly don’t know enough to make informed investment decisions based on the tax consequences of their actions.
The following guide will help you understand the basic rules for the federal capital gains tax. It covers a variety of topics, including what are capital gains, when they’re taxed, how to calculate your gain, and what tax rates apply. It also identifies IRS reporting requirements and provides tips for taking advantage of the preferential rates. It’s not a substitute for sound professional advice, but it will help investors of all sorts understand the general capital gains tax framework and identify areas where professional help is needed.
What are Capital Gains?
Capital gains are the profit you make from selling or trading a “capital asset.” With certain exceptions, a capital asset is generally any property you hold, including:
- Investment property, such as stocks, bonds, cryptocurrency, real estate, and collectibles; and
- Property held for personal use, such as a car, house, or home furnishings.
There are, however, various special rules that may affect your property’s classification or treatment as a capital asset. For instance, if you sell frequently to customers, your property might not be treated as a capital asset. Instead, it may be considered business inventory – and profits from the sale of inventory aren’t taxed as capital gains. So, watch out if you sell too many Gucci handbags or real estate investment properties, as these may be treated as inventory, and the tax on any gains will be at the higher ordinary income tax rates.
Similarly, if you sell or exchange depreciable property to a related person, your gains will be taxed as ordinary income.
In addition, intellectual property (e.g., a patent; invention; model or design; secret formula or process; copyright; literary, musical, or artistic composition; letter or memorandum, etc.) is not considered a capital asset if it’s held by the person who created it or, in the case of a letter, memorandum or similar property, the person for whom it was prepared or produced.
Plus, although real or depreciable property used in a trade or business is not a capital asset, gains from the sale or involuntary conversion of them may nonetheless be treated as capital gains if they were held for more than one year. So, for all practical purposes, this type of business property is treated as if it was a capital asset.
When are Capital Gains Taxed?
Capital gains are taxed when they’re “realized.” Your capital gain (or loss) is generally realized for tax purposes when you sell a capital asset. As a result, capital assets can continue to appreciate (increase in value) without becoming subject to tax as long as you continue to hold on to them. For example, loans against your capital asset don’t give rise to a realization event or capital gains tax. For this reason, many real estate investors will refinance properties rather than sell them.
Other types of events besides sales can also give rise to a “realization.” For instance, property that is involuntarily converted or taken by the government, or over which you grant an exclusive use right to others, may be treated as sold. A capital gain (or loss) is also realized when property is exchanged for other property.
Although the exchange of property generally is a taxable realization event, special rules apply to “like-kind” exchanges of real estate. Among other requirements, the rules require you to find a replacement property within a certain timeframe, but they may help reduce or eliminate your taxable gain.
How to Calculate Taxable Capital Gain
Your taxable capital gain is generally equal to the value that you receive when you sell or exchange a capital asset minus your “basis” in the asset. Your basis is generally what you paid for the asset. Sometimes this is an easy calculation – if you paid $10 for stock and sold it for $100, your capital gain is $90. But in other situations, determining your basis can more be complicated.
Tax Tip: Since your basis is subtracted from the amount you receive when disposing of a capital asset, you want the highest basis possible so that the taxable portion of your profit is as low as possible.
If you sell some but not all the stock you hold in a company, and you acquired stock on different dates, there are several ways to determine your basis. Usually, the first-in-first-out rule applies (i.e., stock you purchased first is considered sold before stock you purchased later). However, the basis might instead be determined by specific identification and matching of each share you bought and sold. You may also elect to use the last-in-first-out rule (i.e., stock you purchased last is considered sold before stock you purchased earlier) or the average cost basis for all shares sold. Given these differences, if you acquired stock on different dates (e.g., through a dividend reinvestment plan), make sure you pay close attention to your method of accounting before selling down your position.
Basis calculations are also more complicated if you acquired the capital asset you’re selling other than by an ordinary purchase. For example, if you inherit an asset, you generally take a “stepped-up” basis (i.e., the asset’s fair market value at the date of the previous owner’s death). If someone gives you a capital asset as a gift, the donor’s basis carries over to you. If you receive stock from your employer as part of your compensation, your basis is generally equal to the amount included in your taxable pay (i.e., reported on your W-2) allocated to the securities.
Your basis can also include more than simply your initial purchase price. For example, your basis can also include expenses related to buying, selling, producing, or improving your capital asset that are not currently deductible. This will reduce your gain when you sell. Home improvement expenses, and brokers’ fees and commissions that are clearly identified with a particular asset can raise your basis. Just make sure you keep receipts and other records related to these additional costs. Also note that certain investment-related expenses are miscellaneous itemized expenses and disallowed through 2025 (nor will these expenses increase your basis).
The amount of capital gain subject to tax can also be reduced if an exclusion applies. Perhaps the best-known capital gains tax exclusion is for the first $250,000 of gain ($500,000 if filing jointly) from the sale of a personal residence you’ve owned and lived in for two of the last five years. In addition, 100% of your gain from the sale of “qualified small business stock” may also be excluded if you acquired the stock after September 27, 2010. If the stock was purchased before that date, you still may be eligible for a partial exclusion of either 50% or 75% of the gain.
Various other actions can impact your basis or the calculation of capital gain. These include, among other things, granting an easement over land you own, taking depreciation deductions for wear and tear on your property, or selling property for less than fair market value (i.e., a “bargain sale”). When more complicated situations like these arise, it’s best to seek a tax professional’s advice before selling or exchanging the related capital asset.
Capital Gains Tax Rates
Long-term capital gains are subject to lower rates of tax than short-term capital gains, which are taxed at ordinary income tax rates. You therefore need to know your holding period for any capital asset you sell. If you hold an asset for more than one year, the gain you realize when you sell it will be long-term capital gain and taxed at the reduced rates. For this reason, you should generally try to hold capital assets for at least one year to get lower rates.
If you sell some but not all your stock in a company, the rules for determining your holding period will depend on your method of accounting for the securities (e.g., FIFO, LIFO, etc., as noted above in relation to determining your basis). You also may get to count the holding period of the person from whom you acquired your stock if you acquired it other than by purchase or other taxable transaction (e.g., if you inherited it).
If you have long-term gains, the next thing you need to know is which capital gains tax bracket you fall into – the 0%, 15%, or 20% bracket. Just like with your wages and other ordinary income, the rate at which you’re taxed on long-term capital gains depends on whether your taxable income is above or below certain thresholds for the year. Unlike tax rate brackets for ordinary income, once your total income is above the relevant threshold, all your capital gains are taxed at the higher rate (so there may be situations where you may come out ahead by earning less total income for the year).
For 2022, the 0% rate applies to people with taxable incomes up to $83,350 for joint filers, $55,800 for head-of-household filers, and $41,675 for single filers and married couples filing separate returns. The 15% rate applies to people with taxable incomes above these limits and up to $517,200 for joint filers, $488,500 for head-of-household filers, $459,750 for single filers, and $258,600 for married couples filing separate returns. If your taxable income is above the 15% bracket, you will pay tax on your capital gains at 20%.
To take advantage of the varied rates, you might want to sell capital assets over a span of years to be taxed at 0% or 15% over several years, instead of selling all your assets at once and having them all taxed at the 20% rate. You can also wait to sell capital assets in years in which you qualify for the 0% rate – e.g., after retirement, after a layoff, or in a year when you’re between jobs or have losses on other capital assets. These strategies are known as “tax gain harvesting.”
Special capital gains tax rates apply when certain assets are sold. For example, any gain from the sale of qualified small business stock that isn’t excluded is subject to a special capital gains tax rate of 28%. A special 25% rate also applies to something called unrecaptured Section 1250 gain. This is generally the amount of depreciation previously taken on real property, but it can’t exceed the amount of gain you realize from the sale of the property. In addition, gains from the sale of collectibles are taxed at 28%. This includes gains from the sale of art, antiques, stamps, coins, gold or other precious metals, gems, historic objects, or another similar items.
Note, however, that the special rates are maximum rates for people with higher incomes. If your ordinary tax rate is lower than the special rate (i.e., either 10%, 12%, 22% or 24%), your ordinary tax rate may apply to gain on qualified small business stock, Section 1250 gain, or collectibles.
Caution: In addition to the capital gains tax, there is also a surtax that applies to “net investment income.” (NII includes, among other things, taxable interest, dividends, gains, passive rents, annuities, and royalties.) If your income is above a certain threshold – $200,000 if single, $250,000 if filing jointly, or $125,000 if married filing a separate return – you generally must pay the additional 3.8% surtax on your capital gains. However, this surtax doesn’t apply to capital gains resulting from the sale of business assets if you’re an active participant or real estate professional.
Tax Loss Harvesting and Carryover of Capital Losses
What if you lose money on your investments? A tax loss can be a valuable asset if you use a strategy called “tax loss harvesting,” which is based on the ability to offset capital gains with capital losses so that you only pay tax on your net capital gains. However, there’s a certain sequence you have to follow when offsetting gains with losses. First, short-term losses are used to offset short-term gains, and long-term losses are used to offset long-term gains. Then, if there are any losses remaining, they can be used to offset the opposite type of gain.
For example, let’s say this year you have the following gains and losses:
- $80 long-term gain from selling A Corp. stock;
- $10 long-term loss from selling B Corp. stock;
- $20 short-term gain from selling C Corp. stock; and
- $50 short-term loss from selling D Corp. stock.
You first offset your $50 short-term capital loss against your $20 short-term capital gain, resulting in a $30 net short-term loss. Then use your $10 long-term loss to offset your $80 long-term gain, resulting in a $70 net long-term gain. The $30 net short-term loss can then be applied against your $70 net long-term gain, resulting in an overall net long-term capital gain of $40.
What if you have an overall net capital loss? Up to $3,000 per year in capital losses ($1,500 if married filing separately) can be used to offset ordinary income (such as wages) in computing your tax liability. You can also carry forward any unused capital losses (i.e., above $3,000) to future tax years until they are used up. But, unfortunately, you can’t carry back your capital losses to prior tax years.
However, if you trade in and out of stocks in an effort to harvest tax losses, pay attention to the “wash sale” rule. This rule prevents you from harvesting a loss on securities you sold if you repurchase the same or substantially identical securities within 30 days before or after your sale. It also applies across your brokerage accounts, so if your investment advisor sells stock of a company at a loss in one of your accounts and you buy the same stock within 30 days in another account, your loss is still disallowed. For this reason, if you engaged in tax loss harvesting, you should consider purchasing a different replacement security.
In addition, losses on the sale or exchange of personal use property are deductible only in very rare circumstances. A deduction is currently only allowed as a personal casualty loss arising from a federally declared disaster, and even then, it’s only allowed to the extent the loss exceeds $100 per casualty and 10% of adjusted gross income (AGI). As a result, as many homeowners who are forced to sell during a financial crisis learn the hard way, you can’t harvest a loss on your personal residence. Of course, these restrictions also prevent you from taking a capital loss on a Gucci handbag that you bought at a fancy store and later sold for a fraction of the original price — even though you would need to report the capital gain if you made a profit on that sale. So, when it comes to paying Uncle Sam, sometimes there’s a bit of “heads he wins, tails you lose.”
Reporting Capital Gains Tax on Your Return
When you file your annual tax return, you’ll have to complete some additional forms if you had a capital gain or loss during the tax year. Report your transactions giving rise to capital gain or loss on Form 8949. This includes capital gains and losses you earn through investments in mutual funds and other investment vehicles, as reported to you on 1099 or K-1 forms. Attach Form 8949 to your return.
Calculate your net capital gain or loss and report capital loss carryforwards from any prior year on Schedule D. You also must attach Schedule D to your Form 1040.
Use Form 4797 to report the sale of depreciable property used in your trade or business (including real estate owned for investment) and depreciation recapture.
You also may be required to pay estimated taxes on capital gains. Generally, you must pay 90% of your current year’s taxes, or an amount equal to 100% of your taxes from the prior year (110% if your AGI was more than $150,000), either through withholding or estimated tax payments. Paying estimated taxes on your capital gains throughout the year will help you satisfy that requirement and avoid penalties at tax time.
State and Local Taxes on Capital Gains
Don’t forget to consider state and local income taxes when you sell a capital asset. Some states and municipalities (like New York City) tax capital gains and others don’t. Whether or not you must pay capital gains tax in a particular state depends not only on where you live but also on the type of asset you’re selling. For example, if you sell real estate, the relevant taxing state is generally the location of the property. However, if you sell stock, it’s your state of residence.
If your capital gain is subject to tax in a state other than where you live, find out if that state will also tax the gain. If so, your state of residence may grant you a credit for any taxes paid to the other state.
Check with the state tax agency where you live to learn more about how your state taxes capital gains.
Other Strategies for Managing Capital Gains Tax (More Tips!)
Now that you have a general understanding of the capital gains tax, here are a few tidbits for a more sophisticated approach to managing your tax liability…
1. When you die, your capital assets will be passed to your heirs, who will inherit a basis in those assets equal to the fair market value of the property on the day of your death. As a result, your heirs can immediately sell the property without incurring taxes on any gains. Therefore, if you’re older and have significantly appreciated assets, you may want to consider holding on to those assets until you die. If you need cash, selling assets with less gain may be a smart move – at least as far as your heirs are concerned.
2. You can donate appreciated stock to charity and receive a charitable deduction for their fair market value (i.e., not just for your basis). Some sophisticated charities will accept other types of appreciated capital assets as well. If you contribute appreciated stock to a donor advised fund, your charitable contribution deduction is realized at the time of your contribution even if the stock is sold and cash grants are made to the charities later. However, there are limits on deductions for charitable donations of capital assets. The amount you can deduct is limited to 50% of your AGI in most cases, though 20% or 30% limits may apply depending on the type of property and the organization receiving your donation.
3. If you’re selling your business or another sizable asset, consider selling in installments over the course of two or more tax years. This strategy lets you shift gains into the following tax year if you expect to be taxed at a lower rate in the later year. Note, however, that some of the consideration you receive may be deemed to be taxable interest on a loan (if unstated or unusually low, the implied interest rate determined by the IRS will apply).
4. Consider investing in qualified opportunity funds (QOF), which in turn invest in economically distressed communities. If you invest your capital gains in a QOF, you defer taxes on those gains until 2026. Plus, all your future capital gains from your QOF investment will be tax-free if you hold the investment for ten years. You may even be able to form your own QOF if you have an idea for a real estate or other business investment in one of the 8,000+ Qualified Opportunity Zones across the country.
5. Remember tax-deferred accounts (401(k)s, traditional IRAs, Roth IRAs, 529 college savings accounts, HSAs, etc.) when acquiring capital assets you expect to appreciate significantly over the course of your holding period. Any gains within these accounts aren’t subject to the capital gains tax.