Understanding & Optimizing Your Capital Gains Tax

Proper capital gains treatment on your investments is essential to assure you earn the maximum amount possible after taxes. There are two types of capital gains tax: short-term and long-term. There are also different rates for different types of investments. Therefore, you must monitor your capital gains treatment to assure you are securing the lowest possible tax rates as well as deferring taxes as necessary or practical.

Capital Gains Tax Rates

As of 2010, the following schedule applies to capital gains taxes:

• Short-term: held for one year or less, paid at your ordinary income tax up to 35 percent
• Long-term: held for one year or more, paid at 0 percent for individuals in the 10 to 15 percent tax bracket and 15 percent for individuals in higher tax brackets
• Short-term collectibles: held for one year or less, same as short-term rate up to 35 percent
• Long-term collectibles: held for one year or more, taxed at 28 percent
• Small business stock: held for more than five years, 28 percent
• Short-term real estate sale of your main home: held for one year or less, equal to your short-term capital gains tax
• Long-term real estate sale of your main home: held for one year or more, equal to your long-term capital gains tax
• Mutual fund capital gains: Reported on a 1099-DIV or 1040 each year if income is earned through dividends or sale; more complicated tax structure based on cost explained in IRS Publication 564

Short-Term vs. Long-Term

As you can see, in every scenario, it is best to hold onto an investment until it reaches the long-term capital gains tax rate when possible. Unfortunately, you may not always have this option if you would like to maximize your profit. There are some investments that present the best opportunity for gains after just a few months. In this case, you can still sell but lower your tax through deferment.

Capital Gains Deferment

Deferment offers a highly advantageous tax structure. Instead of cashing out your profit, you can reinvest it into another form of capital investment. Then, the IRS will continue to roll over the taxes until you finally, upon deciding the time is right to do so, make a sale and collect the profit fully. Since your capital gains tax relates to your income tax bracket, it is best to wait until you are at a low bracket in order to cash out. Retirement, for example, provides a great opportunity to cash out at a low taxable rate.

Short-Term Gains Deferment

You can defer short-term gains, but you should note that this will not help you avoid the short-term tax all together. If you should have owed short-term gains tax on an investment but cashed out at a long-term rate, you may owe the difference between the two taxes upon ultimately selling your investments. One strategy some investors use is to reapply short-term investments to other short-term investments. This will not allow you to escape short-term gains tax, but you will be able to cash out once you are at the lowest tax bracket possible in the future.