How Capital Gains Tax Works

The IRS defines a capital asset as "almost everything you own and use for personal or investment purposes." That's a lot of stuff. So technically, yes, you'd have to tell the IRS about that Bee Gees record. But the most common taxable assets are securities, real estate and valuable collectibles.

Securities are any kind of financial instrument or investment contract that has value. Examples are stocks, bonds and options. Once again, it's important to understand that you'll only be taxed on securities that you've sold in the past year. If your stocks go up during the year, but you hold on to them, you won't be charged a capital gains tax. Other types of investment income that fall into the capital gains category include annual dividends received from certain types of mutual funds and real estate investment trusts (REITs).

If you use a broker to help buy and sell stocks and bonds, then the brokerage firm will send you a form at the beginning of the year called a "1099-B, Proceeds From Broker and Barter Exchange Transactions," which lists all of your earnings and losses from the sale of securities. It's typical for the brokerage firm to list the earnings as net proceeds, meaning how much you earned minus any associated commissions and fees. If they list gross proceeds, then you'll have to deduct the commissions and fees yourself.

If you sell real estate or property, either for personal or business purposes, and make a profit from the sale, then that qualifies as a capital gain. Different tax rates apply to sales of personal and business property. Thanks to the Taxpayer Relief Act of 1997, however, there are some significant tax breaks when you sell your primary residence.

According to the 1997 law, if you've used a home (or apartment, or trailer or even houseboat) as your primary residence for at least two out of the last five years, you can exclude up to $500,000 in capital gains from the sale of that property [source: Investopedia]. The $500,000 exclusion is only for married couples who file jointly. Individual filers can exclude up to $250,000. That means you don't have to pay taxes on money made from selling a primary residence unless the earnings exceed $250,000 or $500,000, depending on your filing status.

Sales of art, rugs, antiques, jewelry, precious metals, wine, stamps, coins and other valuable collectibles are indeed taxable as capital gains. We'll talk more about capital gains tax rates and how to calculate them in the next section.

The first step is calculate exactly how much capital gain you've earned in the last year (yes, you must pay capital gains tax every year). This sounds easy enough. All you have to do is take the sale price of a capital asset (stock, real estate, etc.) and subtract the original purchase price. But it gets a little trickier if you're not the person who originally purchased the asset or investment.

The original purchase price of an investment (like stock, other securities or investment property) is known as the cost basis. There are several different ways to calculate this:

Once you've figured out how much you've earned from the sale of each asset, you need to figure out how long you've owned each asset. This is called the holding period of an investment and is divided into two categories, each with a different tax rate [source: IRS]:

The IRS favors long-term investments over short-term. So the capital gains tax rates for short-term investments are almost always going to be higher than for long-term investments. The specific rates for each holding period depend on what type of asset was sold.

But the most important factor that determines your capital gains tax rate is your income tax bracket. The higher your income tax bracket, the more you're going to pay in capital gains tax. Short-term capital gains are taxed at the ordinary income tax rates, up to 37 percent.

Currently, there are three tax rates for long-term capital gains. When filing in 2021 (for tax year 2020)[source: Bradford Tax Institute]:

There are some exceptions for long-term capital gains rates. The long-term rate for collectibles is currently a flat 28 percent across all tax brackets. That's the same for small business stock held for more than five years. For real estate investments (for instance, selling a house that's not your primary residence), the long-term capital gains tax is either 0, 15 or 20 percent depending on income level as long as you held the asset for at least one year. The income levels are the same as for other long-term capital gains [sources: Kennon, RocketMortgage].

President Joe Biden is calling for an increase in the capital gains tax to 39.6 percent for taxpayers making over $1 million [source: CNBC]. This is to help pay for proposed programs like lower-cost health insurance and free preschool. If this increase passes, it would become effective with next year's tax bill (2022, or the 2021 tax year).

Capital gains earnings, losses and taxes owed are recorded in Schedule D: Capital Gains and Losses of the United States tax return.

Now let's look at a few of the most effective ways to lower your capital gains tax burden.

The simplest strategy for lowering the amount you owe in capital gains tax is to avoid short-term investments. Long-term investments will almost always have a lower tax rate than short-term investments. In the case of the lowest tax brackets, you'll pay nothing for long-term capital gains on most securities.

Capital gains tax should always be considered when making an investment in stocks or other securities. It might seem smart to make a short-term investment with a higher interest rate than a long-term investment with a lower rate. But after capital gains tax is collected, that long-term investment might leave more profit in your pocket.

Another strategy for avoiding high capital gains taxes is to shelter as much income as possible in tax-deferred retirement accounts like 401(k)s, Roth IRAs and Traditional IRAs. The cool thing about these accounts is that you can buy, sell and exchange securities within the account without being charged any capital gains tax. These accounts shelter your investments from capital gains tax as long as any money earned from a sale is reinvested in another security.

When you begin to withdraw money from a retirement account -- after you've reached retirement age -- you'll be taxed at your normal income tax bracket. The advantage here is that when you're retired, you'll probably be in a lower tax bracket than when you were working [source: Investopedia].

The final strategy for lowering your capital gains tax burden involves those capital losses we mentioned before. If you sell an asset for less than its original purchase price, that's a capital loss. You can subtract, or deduct, capital losses from your capital gains to lower your total taxable earnings. A smart strategy is to sell any investments that are losing money within the first year. That way you won't have to pay a high, short-term capital gains tax if they somehow start to earn money.

Interestingly, unlike capital gains, you don't have to apply capital losses to the tax year in which they occurred. It's legal to carry over losses from the current year to one of the next seven years of tax returns. This way you can wait for an especially high capital gains year to use the capital loss deduction.

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