If you make money from just about any source, you’re likely to find Uncle Sam nearby. It’s true of money you earn from a job, and it’s true of money you earn from investments – whether that’s stocks, real estate or collectibles. Any profit you earn from selling an investment is known as a capital gain, and the tax on this form of income is called the capital gains tax. Depending on how long you’ve held the asset before selling it, you’ll be taxed at either the short-term or long-term capital gains rate. In this article we’ll explain how the capital gains tax works, the difference between long- and short-term capital gains, the rates you’ll pay on the federal and state levels, and how to minimize the tax impact on your investments.
A financial advisor can help you tax-optimize your investment portfolio. Find a financial advisor today.
What Are Capital Gains, and How Are They Taxed?
When you buy an investment asset, you’re hoping that it will appreciate in value, thereby giving you the option to sell it for more than you initially paid for it. If you do, these profits are referred to as “capital gains” by the government.
For example, let’s say you buy 10 shares of a company at $12 each, then later sell them at $15 a share. In this case, you have capital gains of $30.
Of course, you won’t always be so lucky. Let’s say another investment doesn’t do as well, and you sell it for less than what you originally paid for it. This is referred to as a capital loss.
At the end of the year, you tally up your capital gains and losses; if you’ve had a good year and your gains exceed your losses, then you deduct your losses from your gains to find your net capital gains.
These gains constitute income, so the federal government (as well as some state governments) will tax them. This is known as the capital gains tax.
Capital Gains Tax Rates: Short-Term vs. Long-Term
The timeline on which you purchase and sell your assets comes into play for capital gains taxes. The government splits capital gains into two categories: short-term and long-term. For investment profits to be considered “long-term,” the asset must be held by the owner for at least one year before sale. Any profits from the sale of assets held for less time than that are considered “short-term” capital gains.
Short-term capital gains are taxed at ordinary income tax rates. This can become problematic for those with a high income, as federal income tax rates can reach as high as 37%. And that doesn’t even account for state taxes.
Long-term capital gains, on the other hand, receive special tax treatment if you reach that one-year threshold. The top federal long-term capital gains rate is 20%, which is lower than all but two of the seven ordinary income tax rates. The other long-term capital gains tax rates are 0% and 15%.
Here is a breakdown of what rates your long-term capital gains will be taxed at for the 2022 tax year:
|Federal Tax Rates for Long-Term Capital Gains|
|Rate||Single||Married Filing Jointly||Married Filing Separately||Head of Household|
|0%||$0 – $41,675||$0 – $83,350||$0 – $41,675||$0 – $55,800|
|15%||$41,676 – $459,750||$83,351 – $517,200||$41,676 – $258,600||$55,801 – $488,500|
Again, short-term capital gains are taxed using the same rates as ordinary income taxes, which are much higher than the rates above. So short-term capital gains are added to your taxable income for the year, and you are charged marginal rates based on which brackets your income falls within. Here’s an overview of the short-term capital gains rates for the 2022 tax year:
|Federal Ordinary Income Tax Rates for Short-Term Capital Gains|
|Rate||Single||Married Filing Jointly||Married Filing Separately||Head of Household|
|10%||$0 – $10,275||$0 – $20,550||$0 – $10,275||$0 – $14,650|
|12%||$10,276 – $41,775||$20,551 – $83,550||$10,276 – $41,775||$14,651 – $55,901|
|22%||$41,776 – $89,075||$83,551 – $178,150||$41,776 – $89,075||$55,901 – $89,050|
|24%||$89,076 – $170,050||$178,151 – $340,100||$89,076 – $170,050||$89,051 – $170,050|
|32%||$170,051 – $215,950||$340,101 – $431,900||$170,051 – $215,950||$170,051 – $215,950|
|35%||$215,951 – $539,900||$431,901 – $647,850||$215,951 – $323,295||$215,951 – $539,900|
How to Calculate Capital Gains Taxes
The first thing you need to determine when calculating capital gains taxes is how much you earned and lost from investments during the tax year. Once you know this, you can subtract your capital losses from your capital gains to get your net capital gains. This is what will be subject to taxes.
Next, you need to figure out which of those capital gains are short-term and long-term. Again, long-term capital gains means at least one year elapsed between the purchase and sale of the asset. Short-term capital gains means less than one year passed between the purchase and sale of the asset.
Long-term capital gains are taxed using a 0% to 20% tax schedule, whereas short-term capital gains are taxed like ordinary income. Long-term taxes work similarly to income taxes, as their brackets are progressive. More specifically, your non-investment income will be considered first, with your investment income coming after. So if your non-capital gains income comes in below your status’ next threshold, but the investment income pushes it past that, then your capital gains will be divided between each bracket accordingly.
Here are some examples of long-term capital gains tax calculations:
|Long-Term Capital Gains Tax Examples|
|Filing Status||Net Capital Gains||Total Taxable Income||Capital Gains Taxes Due|
|Single||$20,000 (gains) – $5,000 (losses) = $15,000||$50,000 (salary) + $15,000 (capital gains) = $65,000||$15,000 x 15% = $2,250|
|Married Filing Jointly||$40,000 (gains) – $10,000 (losses) = $30,000||$150,000 (salary) + $30,000 (capital gains) = $180,000||$30,000 x 15% = $4,500|
|Married Filing Separately||$10,000 (gains) – $3,000 (losses) = $7,000||$250,000 (salary) + $7,000 (capital gains) = $257,000||($800 x 15%) + ($6,200 x 20%) = $1,360|
|Head of Household||$12,000 (gains) – $2,000 (losses) = $10,000||$40,000 (salary) + $10,000 (capital gains) = $50,000||$10,000 x 0% = $0|
Which States Levy Capital Gains Taxes?
The majority of U.S. states charge a state-level capital gains tax. That means you may owe both state and federal taxes on your investment income. However, some states allow you to deduct your federal taxes from your taxable state income. This should help you minimize your state taxes if your state offers that deduction.
There are only nine states in the U.S. that don’t have a capital gains tax. They are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. All 41 other states have some kind of capital gains tax, as does Washington, D.C. For 2022, capital gains tax rates in these states range from 2.9% in North Dakota up to 13.3% in California.
How the Capital Gains Tax Interacts With Other Taxes
Beyond capital gains taxes, if you’re a high-income individual with a large portion of your income coming from investing, you may encounter the net investment income tax (NIIT). This 3.8% tax applies to individuals who have capital gains with a modified adjusted gross income (MAGI) above certain thresholds. Here’s a breakdown of the NIIT MAGI limits by tax status:
|Net Investment Income Tax (NIIT) Thresholds|
|Your Filing Status||Threshold Amount|
|Married Filing Jointly||$250,000|
|Married Filing Separately||$125,000|
|Head of Household (With Qualifying Person)||$200,000|
|Qualifying Widow(er) With Dependent Child||$250,000|
The alternative minimum tax (AMT) can also come into play with capital gains. This is essentially a separate tax system that runs parallel to our traditional income tax brackets and rules. It’s a much more inclusive system, meaning it taxes more types of income and gets rid of some deductions and credits. It was created in the 1960s as a way to ensure more taxes are paid by those who take heavy advantage of tax-free forms of income.
One situation where AMT can get involved is when you have high capital gains for the tax year. If your total income (wages and capital gains) surpasses prescribed AMT exemptions for the current tax year, then you’ll need to perform an AMT calculation. For 2022, the AMT exemptions are as follows:
Another situation that can come into play is if you have unrealized capital gains from exercised qualified incentive stock options (ISOs). These are typically available to employees of companies where the company allows them to buy stocks at a cheaper price. Despite the fact that you may have yet to sell the exercised ISOs, you’ve received a profit by virtue of the lower costs.
So let’s say you’ve triggered the AMT through one of the two means above. You’ll then need to run your taxes through the AMT, as well as the traditional income tax system. This is done by using IRS Form 6251. If your AMT comes out below your normal income tax return, then you won’t own anything extra. But if your AMT is higher than the taxes on your normal income tax return, then you’ll have to pay both your original taxes and the difference up to the AMT.
Planning Ahead for Capital Gains Taxes
If you’re trying to minimize your capital gains taxes, the best thing you can do is hold onto your assets for at least one year. While this might not always be possible, especially with the ebbs and flows of the stock market, you’ll receive much more preferential tax treatment if you can manage to do so.
Another way to avoid capital gains taxes is to utilize any capital losses you may have for the tax year. So if you sell some investments for a gain and others for a loss, but overall you came out on top, then you can deduct your losses from your gains to minimize your capital gains. This will help you decrease your taxable capital gains for the year, while also softening the blow of losing money. Additionally, if your capital losses outweigh your capital gains, you can deduct a certain amount from your taxable income. The amount you can deduct is the lesser of $3,000 or your total net capital losses.
If you’re saving for retirement and want to avoid capital gains taxes, use whatever tax-deferred accounts you have available to you. This could include an individual retirement account (IRA) or an employer-sponsored 401(k). By using these, you defer your taxes until retirement, though they will incur ordinary income taxes. However, because your non-investment income will likely be low when you retire, those taxes should be fairly manageable.
Capital Gains Tax Deductions and Special Circumstances
When you sell your own home, you may be subject to capital gains taxes, though things work a bit differently with real estate investments. For instance, if you’re single, you can make up to $250,000 profit on your home without incurring capital gains taxes. For married couples filing jointly, this exclusion goes up to $500,000. If you exceed those marks, you’ll be subject to some capital gains taxes.
Collectibles are another area of capital gains that are taxed differently than standard investments. In fact, all collectibles, like art, jewelry, baseball cards and more, are taxed at a flat 28% rate.
Making money from investments like stocks, stock options and real estate can be beneficial to your financial plans. However, there are many rules surrounding this type of income, with rate differences between short- and long-term capital gains being one of the most obvious. You can never plan ahead too much, simply to ensure you don’t get hit hard come tax time each year.
Tips for Capital Gains Tax Planning
Photo credits: ©iStock.com/SrdjanPav, ©iStock.com/Koonsiri Boonnak, ©iStock.com/FG Trade