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Capital Gains

Photo credit: © iStock/James Brey

If you are reading about capital gains, it probably either means your investments have performed well or you are preparing for when they do in the future. If you’ve built a low-cost, diversified portfolio and the assets you hold are now worth more than what you paid for them, you might be thinking about selling some assets to realize those capital gains. That's the good news. The not-so-good news is that your gains are subject to taxation at the federal and state level. Let's talk about capital gains taxes - what they are, how they work and why exactly you should care about them.

Capital Gains: The Basics

Let's say you buy some stock for a low price and after a certain period of time the value of that stock has risen substantially. Nice work! You decide you want to sell your stock and capitalize on that increase in value. The IRS will have something to say about it.

The profit you make when you sell assets is equal to your capital gains on the sale. Capital gains are taxed at the federal level and in some states at the state level, too. The capital gains tax rate varies based in part on how long you hold the asset before selling.

There are short-term capital gains and long-term capital gains and they're taxed at different rates. Short-term capital gains are gains on assets you hold for a year or less. They're taxed like regular income. Long-term capital gains are gains on assets you hold for over a year. They're taxed at a separate rate.

Depending on your income tax bracket, your tax rate on long-term capital gains could be 0%. Even those in the top income tax bracket pay long-term capital gains rates that are lower than their income tax rates. That's why some very rich Americans don't pay as much in taxes as you might expect.

To recap, the amount you'll pay in federal capital gains taxes is based on the size of your gains, your federal income tax bracket and whether your gains are short-term or long-term.

To figure out the size of your capital gains you'll need to know what your basis is. Basis is the amount you've paid for an asset. You don't have to pay capital gains taxes on your basis. Instead, your tax liability stems from the difference between the sale price of your asset and the basis you have in that asset. In other words, your profit.

Earned vs. Unearned Income

Photo credit: © iStock/samdiesel

Why the difference between the regular income tax and the tax on long-term capital gains at the federal level? It comes down to the difference between earned and unearned income. In the eyes of the IRS, these two forms of income are different and deserve different tax treatment.

Earned income is the income you make from your job. Whether you own your own business or pick up a few shifts at the coffee shop down the street, the money you make is earned income.

Unearned income is income that comes from interest, dividends and capital gains. It's money that you make with other money. Even if you're actively day trading away on your laptop, the income you make from your investments is considered passive, unearned income. "Unearned" doesn't mean you don't deserve that money, it's just different.

The issue of how to tax unearned income is pretty political. Some folks say it should be taxed at a rate higher than the earned income tax rate because it is money that people make without working, not from the sweat of their brow. Others think the rate should be even lower than it is - preferably as low as possible to encourage investment.

Tax Loss Harvesting

Photo credit: © iStock/banarfilardhi

Pretty much no one likes to face a giant tax bill come April. Of the many (legal) ways to lower your tax liability, tax loss harvesting is among the more complicated.

Tax loss harvesting is a way to avoid paying capital gains taxes by selling unprofitable investments to offset the capital gains realized from selling profitable investments. You can write off those losses when you sell the depreciated asset, canceling out some or all of your capital gains on appreciated assets. You can even wait and re-purchase the assets you sold at a loss if you want them back, but you'll still get a tax write-off if you time it right.

Some people are devotees of the tax loss harvesting strategy. They say it saves you big bucks. Others aren't so sure. They say that it costs you more in the long run because you're selling assets that could appreciate in the future for a short-term tax break. You're basing your investing strategy not on long-term considerations and diversification but on a short-term tax cut. And if you repurchase the stock you're essentially deferring your capital gains taxation to a later year. Critics of tax loss harvesting also say that, since there's no way of knowing what changes Congress will make to the tax code, you run the risk of paying high taxes when you sell your assets later.

State Taxes on Capital Gains

Capital gains aren't just taxed at the federal level. Some states levy taxes on capital gains, too. Most states tax capital gains as they tax regular income. So, if you're lucky enough to live somewhere with no state income tax you won't have to worry about capital gains taxes at the state level.

New Hampshire and Tennessee don't tax income but do tax dividends and interest. The usual high-income tax suspects (California, New York, Oregon, Minnesota, New Jersey and Vermont) have high taxes on capital gains, too. A good capital gains calculator takes both federal and state taxation into account.

Capital Gains Taxes on Property

If you own a home you may be wondering how the government taxes profits from home sales. As with other assets such as stocks, capital gains on a home are equal to the difference between the sale price and the seller's basis.

Your basis in your home is what you paid for it, plus closing costs and non-decorative investments you made in the property, like a new roof. You can also add sales expenses like real estate agent fees to your basis. Subtract that from the sale price and you get the capital gains. $250,000 of capital gains from the sale of your primary residence (or $500,000 for a couple) are exempted from capital gains taxation. This is generally true only if you have owned and used your home as your main residence for at least two out of the five years prior to the sale.

But what if you inherit a home? You don't get the $250,000 exemption unless you've owned the house for at least two years as your primary residence. But you still get a break. The key concept to understand is "step up." No, we're not talking about the popular series of dance movies. When you inherit a home you get a "step up in basis."

Say your mother's basis in the family home was $200,000. Today the market value of the home is $300,000. If your mom passes on the home to you you'll automatically get a stepped up basis equal to the market value of $300,000. If you sell the home for that amount you don't have to pay capital gains taxes. If you later sell the home for $350,000 you only pay capital gains taxes on the $50,000 difference between the sale price and your stepped up basis. If you’ve owned it for more than two years and used it as your primary residence, you wouldn’t pay any capital gains taxes.

Nice, right? Stepped up basis is somewhat controversial and might not be around forever. As always, the more valuable your family's estate, the more it pays to consult a professional tax adviser who can work with you on minimizing taxes if that's your goal.

Bottom Line

At SmartAsset we're all about investing in your future. If your investments perform well and you want to sell up you'll have higher tax bills to match. It's up to you to decide the lengths you want to go to in the quest to trim your capital gains tax liability. If you decide to go with a "buy and hold" strategy you won't have to think too much about capital gains until you make a major financial move like tapping into your retirement accounts.

Places with the Savviest Investors

SmartAsset’s interactive map highlights the places in America with the savviest investors. Zoom between states and the national map to see where in the country the best investors live.

Least
Most
Rank City Annual Return Volatility Post-Tax Return

Methodology Our study aims to find the places in the country with the savviest investors. We wanted to find where people are not only seeing good returns on their investments but where they are doing so without taking too much risk.

In order to find the places with the savviest investors we calculated investment returns and portfolio volatility over the last year. We focused on data of user portfolios provided by our partner Openfolio.

We calculated the risk-adjusted return of the stocks using the Sharpe Ratio. The Sharpe Ratio is the stock return minus the risk-free rate divided by volatility.

We indexed and ranked each of the locations based on this risk-adjusted return to find the places where people were seeing the best returns for the least risk.

Finally, we calculated the amount of money investors were taking home after paying both federal and state capital gains taxes.

Sources: Openfolio - "Openfolio is a free and open network that lets people share their portfolios - but no dollar amounts, only percentages. The idea is that sharing will help everyone be better informed, like with this map."

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