A capital asset is property. A capital asset can be real property (e.g.,a home or land) or can be personal property, such as jewels or artwork. Both businesses and individuals may own capital assets. The law taxes the sale of capital assets. If an individual sells a capital asset at a price greater than the price they paid for the asset, the individual has realized what the law calls capital gain.
The amount of profit (the difference between the sale price and the initial purchase price), or capital gain, is taxed. Capital gains are considered to be part of an individual’s income. They are subject to a special tax known as the capital gains tax.
What is a Capital Gain?
A capital gain occurs when an individual holding a capital asset “makes money” on the sale of that asset. Take the purchase of land as an example. An individual may purchase a piece of empty land. The price at time of purchase is, say $100,000.00. The individual purchases the land in the hope that future developments or the passage of time make the land more valuable.
That way, when the person sells the land, the person receives more money for the sale, than what they initially paid. Say that after a few years, oil is found under the land. Oil is a valuable resource. Land containing oil is considered to be valuable property. As a result of the oil finding, the property value rises from $100,000 to $600,000. If and when the owner sells the property at this higher value of $600,000, the person has realized a capital gain. The amount of the capital gain equals the increased price, minus the purchase price, or, $600,000-$100,000. The amount of the capital gain is $500,000.
What is the Capital Gains Tax?
The Internal Revenue Code, which is the law that sets forth who must pay taxes, when taxes must be paid, and the rate of taxation, requires that individuals pay taxes on capital gains. The capital gains tax rate depends upon whether the capital gains are long-term or short-term gains.
In general, the Internal Revenue Service (IRS), which administers the tax code, considers assets held for one year or less before being sold, to be “short-term assets.” The one-year “clock” begins on the day after the capital was purchased. The clock “stops” on the date of sale. The amount at ws a tax on profits from the sale of an asset held for one year or less. In general, the capital gains tax rate for short-term gains is the amount at which an individual’s ordinary income is taxed. This amount is referred to as an individual’s “tax bracket.”
As of 2020, there are seven ordinary income tax brackets: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent. Taxation in the United States is progressive. This means that the greater one’s income, the higher percent at which that income is taxed. For example, the initial $9,875 of the income of an individual who earns $600,000, is taxed at 10%. Once the individual has earned $40,126, the income between $40,126 and $8,2525 is taxed at 22%.
The tax rate for each additional margin, or amount, of income, increases. Once the individual has earned $518,400, all income above that amount is charged at 37%. An individual’s highest tax percentage, which here is 37%, is the individual’s tax bracket. Short-term capital gains income is taxed at the rate of that bracket. In the case of the individual who has already earned $600,000, a short-term capital gain of $2,000 is taxed at the 37% rate.
Long-term capital assets are those held for more than a year before they are sold. The amount of capital gain on long-term capital assets is subject to capital gains tax. The long-term capital gains tax rate is one of three numbers: 0%, 15% or 20%. The rate depends on an individual’s taxable income, and filing status (e.g., single, married). On the whole, long-term capital gains are taxed at a lower rate than short-term capital gains.
Can I Deduct for Capital Losses?
Capital losses can be deducted from one’s total taxable income, thereby reducing the total tax bill. Currently, short-term capital losses can be used to offset those short-term capital gains made in a tax year. This allows an individual to report a lower income number on their return. Say, for tax year 2020, an individual has short-term capital gains of $2,000 and short-term capital losses of $5,000. The individual has a net capital loss of $3000 ($2000-$5000) and can subtract that figure from their total taxable income amount.
In many instances, an individual has no capital gains to offset a capital loss or losses. If this is the case, capital losses may be used to “offset” (be subtracted from) ordinary income. The offset may be made for up to $3,000 worth of losses in a tax year.
Are There More Ways to Reduce or Avoid Paying the Capital Gains Tax?
Individuals may be able to reduce the amount of capital gains tax, or avoid payment of the tax. One way to do this is to make investments on a long-term, rather than short-term, basis. Assets that are held for more than a year are generally taxed at a lower capital gains tax rate than are assets held for under a year.
Another method of reducing the amount of capital gains tax is to offset short-term capital gains with short-term capital losses. If the latter exceeds the former for a given year, an individual has sustained a net capital loss. The individual will not be taxed for capital gains because there are no gains to tax.
Another method of capital gains tax reduction is to enroll in a tax-deferred retirement plan. Retirement plans include those sponsored by an employer (401k) or plans in which an individual sets up and manages the plan (IRA). An individual must pay taxes on retirement plan investment income.
These taxes can be paid on a deferred basis, meaning that the taxes will be due only when the individual takes the money out of the account upon reaching retirement age. The money is not taxed immediately. Deferring taxation allows an individual to accrue capital gains, without having to pay taxes on those gains until retirement.
Do I Have to Pay Capital Gains Tax If I Sell My House?
In general, an individual is exempt from part or all of capital gains tax on the sale of their home. This is the case if the home is being used as the individual’s primary residence. Currently, to avoid capital gains tax on the sale of a primary residence, the residence must have been the primary residence for two years or more during the period immediately before the sale.
A single individual is allowed to claim a $250,000 exemption for capital gains from a home sale. This means the person pays no capital gains on the first $250,000 earned through the sale. The amount that exceeds $250,000 remains subject to capital gains tax.
Should I Contact a Lawyer for Issues with the Capital Gains Tax?
If you have capital gains tax concerns, you should seek capital gains tax advice. You can seek this advice by contacting a tax attorney. An experienced business lawyer near you can advise you as to what constitutes capital gains, and can assist you with preparing a capital gains tax strategy that minimizes the amount of capital gains tax to be paid.
