Understanding & Minimizing Capital Gains Taxes

Most people are familiar with income taxes and sales taxes. Income taxes are automatically withheld from pay or paid by independent contractors, self-employed individuals and some others based on how much money is earned. Sales taxes, meanwhile, are paid at the point of purchase when we buy retail goods and some services.

But there’s another kind of tax that’s often not as well-understood: capital gains taxes. These are owed when an asset, such as investment securities or real estate, is sold for more money than was paid for the asset.

Tax efficiency is an important aspect of managing your investments. Learn how to keep growing your net worth with our free guide 5 Tax Hacks for Investors.

How Capital Gains Are Computed

A capital gain is computed by subtracting the purchase price of an asset from the selling price. So if you bought a stock for $1,000 and sold it for $2,000, you would realize a capital gain of $1,000 (2,000 – 1,000 = 1,000). You will owe tax on this $1,000 capital gain during the year when you sold the asset.

Note that tax is only owed on capital gains when they are realized, or sold. If you hold onto this stock instead of selling it, you have what’s termed an unrealized capital gain. No tax would be due on the gain until you sold the asset. 

The rate of tax that’s due on capital gains depends on how long you hold the asset. If you hold a stock for one year or longer, your gain will be taxed at the long-term capital gains tax rate. But if you hold a stock for less than one year before selling it, your gain will be taxed at your ordinary income tax rate. 

Long-term capital gains tax rates are based on adjusted gross income (AGI). If AGI is lower than $40,000 (or $80,000 for married couples filing jointly), the capital gains tax rate is currently zero. If AGI is between $40,000 and $441,450 (or $80,00 and $496,600 for married couples filing jointly) the capital gains tax rate is currently 15%. And if AGI is over $441,450 (or $496,600 for married couples filing jointly), the capital gains tax rate is currently 20%.

Avoiding or Minimizing Capital Gains Taxes

There are several strategies you can implement that can help you avoid or minimize capital gains taxes. Here are six.

1. Hold onto taxable assets for the long term. The easiest way to lower capital gains taxes is to simply hold taxable assets for one year or longer to benefit from the long-term capital gains tax rate. While marginal tax brackets and capital gains tax rates change over time, the maximum tax rate on ordinary income is usually higher than the maximum tax rate on capital gains. Therefore, it usually makes sense from a tax standpoint to try to hold onto taxable assets for at least one year, if possible.
2. Make investments within tax-deferred retirement plans. When you buy and sell investment securities inside of tax-deferred retirement plans like IRAs and 401k plans, no capital gains tax liability is triggered. Capital gains aren’t taxed until you begin withdrawing funds in retirement, at which time you may be in a lower tax bracket than you are now.

Since retirement account funds are able to grow on a tax-deferred basis, the account balances may grow even more than they would if capital gains taxes were assessed pre-retirement. Roth IRAs and 401k plans take this one step further: Capital gains taxes aren’t assessed even when funds are withdrawn in retirement as long certain rules are followed.

3. Utilize tax-loss harvesting. This strategy involves selling underperforming investments and booking a loss. You can use these capital losses to offset taxable investment gains and up to $3,000 each year of ordinary income. Unused investment losses each year can be carried forward indefinitely to offset capital gains and ordinary income in future years.

For example, suppose you realized a taxable profit of $5,000 on a stock sale this year. However, you own a stock that has fallen in value by $2,000 and you don’t expect it to recover anytime soon. You could sell this stock, book the $2,000 loss and reduce the taxable gain on the other stock to just $3,000.

It’s important to note that you can buy back the stock you sold at a loss if you wait at least 30 days to do so. If you buy it back sooner than this, the so-called “wash-sale rule” will prohibit you from using the loss to offset the capital gain.

Read More: Guide to Tax-Loss Harvesting

4. Donate appreciated investments to charity.  Investments that have appreciated in value from when you purchased them can be donated to charity.  You will receive a charitable donation tax deduction for the fair market value of the investment on the date of the charitable donation and will not pay capital gains tax on the investments donated to the charity.         

Read More: Tax-Wise Charitable Giving: Donating Appreciated Assets

5. Take advantage of the home sale exclusion. Tax law provides a capital gains tax exclusion of up to $250,000 (or $500,000 for married couples filing jointly) on profits from the sale of a home. So if you sell your home for $200,000 more than you paid for it, you won’t owe any capital gains tax on your $200,000 profit.

Keep in mind that this exclusion only applies to a home if it is your primary residence — it doesn’t apply to rental properties. Also, you must have lived in the home for at least two of the past five years (you don’t have to have lived in the home for two consecutive years, however). Finally, you can only take advantage of this exclusion once every two years.

You can subtract your full cost basis in the home from the sale price when making the capital gains tax exclusion calculation. Determine your cost basis by adding the cost of home additions and improvements with a useful life of more than one year to the sale price, along with expenses associated with the purchase and sale of the home. The former include closing costs, title insurance and settlement fees, while the latter include real estate commissions and attorney’s fees. 

Deducting these costs from the sale price of the home will lower your capital gain on the home sale, which could make a difference if you’re right on the edge of the $250,000/$500,000 exemption threshold.  

6. Defer capital gains tax on rental real estate with a 1031 exchange. Tax code section 1031 provides a way to defer the capital gains tax on the profit you make on the sale of a rental property by rolling the proceeds of the sale into a new property.  Specific rules  must be followed to properly complete the 1031 exchange so the use of a qualified 1031 exchange intermediary escrow company is utilized for this type of transaction.  The capital gains tax will be paid once the new property is sold.  Savvy real estate investors may decide to defer the capital gains on rental property indefinitely by continuing to use 1031 exchange transactions for all of their rental property sales.    

Next Steps for You

The strategies involved in avoiding and minimizing capital gains taxes can be complicated. Therefore, be sure to talk to your tax advisor and personal financial planner for guidance in your specific situation.

You can also keep track of all your assets in one place by using online financial tools. Millions of people use Personal Capital‘s free technology to better see their financial picture. Using the tools, you can:

• Analyze your investments and uncover hidden fees
• Budget and save for your short-term and long-term goals
• Plan for retirement given a wide range of scenarios