Markets have been in the bull phase for most of the past decade, which means most investors have needed to get awfully cuddly with the capital gains tax.
It’s not a bad problem to have.
Still, the capital gains tax can be confusing, and you have to keep a number of things to keep in mind with respect to how the system works.
For one, there are quite a few tax terms, including …
- Capital Asset: The IRS definition is a bit fuzzy, but for the most part, a capital asset is anything that is property that may generate a return, such as a stock, bond, mutual fund, a rental or even a home.
- Cost Basis: This is what you pay for a capital asset. This includes any fees, such as commissions or sales taxes. You can also include the cost of improvements, such as adding a room on a home or rental.
- Realized: This is what you receive when you sell the capital asset.
Capital gains tax applies to realized gains/losses. You calculate this by subtracting the amount realized from the cost basis.
For example, suppose you purchased 100 shares of Facebook Inc (NASDAQ:FB) when the stock price was at $90. This means your cost basis is $9,000. Later, you sell your shares when the price is $110, which gives you a realized amount of $11,000. Your capital gain is $2,000.
All of this should be recorded in your brokerage account, so you shouldn’t have to do the math yourself. What’s more, you’ll get a full-year tax statement that will allow you to complete your tax return.
Calculating the Capital Gains Tax
The tax you must pay will depend on your taxable income, filing status and the length of time you have held onto the capital asset.
Continuing our Facebook example, suppose you sold the stock within a year or less. In this case, the taxes you will pay will be at your “ordinary” rates — whatever your income is typically taxed at. This means you could pay as much as 39.6% depending on your tax bracket.
However, you get a big-time tax advantage if you hold onto the capital asset for more than a year before realizing the gain. That makes you eligible for the long-term capital gains tax.