# How Capital Gains Tax Works

## Calculating Capital Gains

Calculating your capital gains taxes can get tricky.
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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:

• If you purchased the investment, then the cost basis is the price you paid for it.
• If you inherited the investment, then the cost basis is the value of the investment on the date that the original owner died.
• If you received the investment as a gift, then the cost basis is the original price of the asset, unless the investment was worth less than that amount when it was given to you. [source: InvestorGuide].

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 three categories, each with a different tax rate:

• Short-term investments are those that are sold less than a year after they were purchased.
• Long-term investments are held for a least a year before being sold.
• Super-long-term investments must be held for over five years after the original purchase. This category is only good for investments purchased after January 1, 2001 [source: Investopedia].

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. As a general rule, you pay capital gains tax at the same rate as income tax for all short-term investments. So if you're in the 10 percent income tax bracket, you'll pay 10 percent for all short-term capital gains. And if you're in the 35 percent income tax bracket, you'll pay 35 percent for all short-term capital gains.

Long-term capital gains have set rates. When filing in 2019 (for tax year 2018), taxpayers earning less than \$38,600 will pay 0 percent on long-term capital gains. Those earnings \$38,601 to \$425,800 will pay 15 percent. Those earning over \$425,800 will pay 20 percent.

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, the long-term capital gains tax is either 5 percent or 15 percent depending on income level as long as you held the asset for at least one year [source: Kennon].

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.