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.
Let’s say you are married. In this situation, you will not have to pay any taxes on a capital gain if you are in the 10% or 15% tax brackets. This means you get a free ride for up to a taxable income of $75,300.
Here’s a full breakdown of long-term capital gains rates:
- If you’re in the 10% or 15% marginal tax bracket, you’ll pay 0% in long-term capital gains taxes.
- If you’re in the 25%, 28%, 33% or 35% marginal tax brackets, you’ll pay 15% in long-term capital gains taxes.
- If you’re in the 39.6% marginal tax bracket, you’ll pay 20% in long-term capital gains taxes.
High-income earners do have to contend with the Net Investment Income Tax (NIIT), which was established to help fund the Affordable Care Act. The rate is 3.8% for investment income — capital gains as well as interest, dividends, rental income and business income — for those with Adjusted Gross Income (AGI) of $200,000 for single filers and $250,000 for those who file jointly.
Still, the long-term capital gains tax rate is a great deal. And it is a major reason why many wealthy people have relatively low tax rates.
But what if you realize a capital loss?
In this situation, you can offset these against any of your gains. You net short-term capital gains against short-term capital losses, then long-term capital gains against long-term capital losses. You then net short-term and long-term, and if that’s a loss, you can deduct up to $3,000 of that loss per year. Better still, you can carry forward the balance to future tax years.