How to Understand Capital Gains Tax

If you realize a profit on something you sell, you may be subject to capital gains tax. Capital gains taxes levy a tax on income from the sale of assets as opposed to income from wages. While only a minority of Americans are subject to capital gains tax, it is important to familiarize yourself it in case you realize a significant profit from the sale of an asset.

Method 1

Method 1 of 3:

Understanding the Basics

1
Start at square one. A capital gains tax is a tax on the profits from the sale of an asset. The asset could be virtually anything, such as a home, a piece of land, stocks, bonds, collectibles—even an intangible asset, like a trademark or a patent.^{[1]XTrustworthy SourceInternal Revenue ServiceU.S. government agency in charge of managing the Federal Tax CodeGo to source}
- In this sense, capital just means money, and gains mean profit.
- Most people's income comes from wages, and that's mostly what ordinary income tax covers. So think of income tax as a tax on wages, and capital gains tax as a tax on selling things.
2
Decide if capital gains taxes even apply to you. If you derive all or most of your income from wages—a paycheck from an employer—then capital gains taxes probably don't apply to you at all, because most people who derive most of their income from wages don't make enough money from the sale of assets for the capital gains tax to kick in. Also, there are a couple forms of income which are definitely derived from the sale of assets, but for one reason or another aren't subject to the capital gains tax.^{[2]XResearch source}
- Short term capital gains, or capital gains on assets held less than a year, are always subject to ordinary income tax rates. For example, a day trader who buys stocks and quickly resells them is subject to the ordinary income tax rate, as is an heir who immediately sells a piece of property they inherited.
- If the profits from the sale of your asset are less than $37,650 (or $75,300 for a married filer) AND the asset sold is something other than a collectible or small business stock, you pay no tax at all. Collectibles are items that people collect and sell, like a comic books or Beanie Babies.
3
Take your losses into account. If you have made more from the sale of an asset than the minimums described above, you'll need to factor in your capital losses in order to get a clear picture of your capital gains.^{[3]XResearch source}
- Calculating the net gain or loss is easy. You simply take your losses and subtract them from your gains. If you've lost more than you've gained, you won't be subject to any tax. As long as the loss didn't stem from the sale of personal property, like your residence, you can deduct up to $3000 per year from your personal income, and carry over additional losses into the following years.
- Say you had a net loss of $9,000 for 2016. You can deduct $3,000 from your income in 2016, another $3,000 in 2017, and another $3,000 in 2018--even if you had net gains in 2017 and 2018.
4
Determine which tax bracket you fall into. If you've still made more than the minimum after calculating your net gain, you need to decide which tax bracket you'll fall into. You can take a look at the various tax brackets for single and married filers at http://www.schwab.com/public/schwab/nn/articles/Taxes-Whats-New.
- The tax rate for collectibles is different than the tax rate for conventional capital gains. Capital gains from collectible are taxed at the same rate as income from wages, with a cap of 28% (instead of 39% for wage income).^{[4]XResearch source}
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Method 2

Method 2 of 3:

Using More Sophisticated Tools to Minimize your Tax Burden

1
Claim the personal residence exemption. Because of the personal residence exemption, most people will never pay federal capital gains tax on the sale of their home. Under this exemption, no tax is applied on the sale of a personal residence where the capital gain is less than $250,000 for a single filer and $500,000 for a married couple, as long as the filer has lived in the home for two of the past five years.^{[5]XResearch source}
- If the filer had to sell the home due to military service, health, or an unforeseen change in employment, they don't even have to meet the two year residence rule.^{[6]XResearch source}
2
Sell stocks using a versus purchase. A versus purchase is just a fancy way of saying that you can pick which “lots” of stock you want to sell. That means that you can tweak the amount of capital gains you'll have to report on your tax return. For example:^{[7]XResearch source}
- Say you bought 10 shares of stock in XYZ corp. at $100 in January and another 10 shares in June for a total of twenty shares. In the first six months you held XYZ stock, the value increased by 10%, to $110. The ten shares you bought in June were purchased for $110, and by the end of the year, your total purchase of twenty shares has increased in value by another 10%. The capital gains on the first lot are going to be $21, while the capital gains on the second lot are going to be $11. If you want to sell ten shares at the end of the year, you can specify that you're selling the shares purchased in June in order to minimize the tax paid.
3
Defer taxes with a like-kind exchange. Tax deferral doesn't exactly stop you from having to pay tax, but it does delay it. If you have reason to believe that a capital gain will be smaller in the future, you are anticipating a future loss, or just need more money in the short term, you can defer your taxes with a like-kind exchange. A like-kind exchange occurs when one type of asset is sold and the money from the sale is immediately used to purchase the same type of asset.^{[8]XTrustworthy SourceInternal Revenue ServiceU.S. government agency in charge of managing the Federal Tax CodeGo to source}
- These like-kind exchanges are usually classified as Section 1031 exchanges, named after the section of the tax code which provides for them. Only certain types of properties are covered under a 1031 exchange, such as real or personal investment property. Stocks, bonds, and personal residences are not covered.
- The replacement property must be located within 45 days, and the purchase completed within 180 days. The IRS will ask for a detailed description of the transaction to be recorded on Form 8824, which can be found at https://www.irs.gov/pub/irs-pdf/f8824.pdf.
4
Set up a trust. Setting up a Charitable Remainder Trust (CRT) is a well established method of avoiding capital gains taxes, although it isn't of use to everyone. But if an investor has sufficient assets, it can be a great way to avoid capital gains taxes, because charities don't pay capital gains taxes at all.
- The investor sets up a trust which must have an expiration date—often the end of the investor's life. Then the investor transfers assets to the trust. The trust pays the investor an annuity from the sale of the assets. When the trust dissolves, whatever is leftover goes to a charity of the investor's choosing.
- At least 10% of the value of the original assets transferred to the trust must go to charity, or other assets will be seized to make up the difference.
- There are two major drawbacks to setting up a trust. For one, the terms of the trust are permanent, and two, it disinherits the investor's heirs from any of the assets transferred to the trust.
- Since the investor must have sufficient assets to set up an annuity payment funded from the sale of the assets and it takes away the ability for the investor to pass the assets along to their heirs, CRTs are usually reserved for the very wealthy.
5
Give assets away. Although it might seem that giving assets away trades a 15% or 20% loss for a total loss, the truth is not so simple. In reality, gifting assets to a family member or trusted associate can be a great way to avoid capital gains tax.^{[9]XResearch source}
- For example, if your total capital gains for the year are more than $500,000, that would put you in the highest capital gains tax bracket (20%). But if you give your five children equal shares of the $500,000, then you reduce the capital gains tax from $100,000 to $75,000.
- However, if you are giving large sums of money, then you may be subject to a gift tax. You can avoid paying a gift tax by strategically giving your gifts. Only large sums of money or high valued property will be taxed.
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Method 3

Method 3 of 3:

Learning the Rationale behind Capital Gains Taxes

1
Think about what capital gains taxes incentivize. Since capital gains taxes are taxed at lower rates than wages (often called unearned vs. earned income), they reward individuals who make a living from the sale of assets.^{[10]XResearch source}
- Since only assets which are held for more than a year are given preferential treatment, they encourage investors to target investments that will be productive over a longer period of time. Theoretically, this encourages people to invest money in ventures that increase productivity.
2
Recognize that capital gains taxes discourage speculation. Since only long term capital gains receive preferential tax treatment, capital gains taxes not only encourage long term investment, they discourage people from buying and selling assets quickly.^{[11]XResearch source}
- The quick buying and selling of assets is known as "speculation." Speculation is more like gambling than investment. The speculator is betting that the price for the asset will go up—for whatever reason—at which point they will sell it. An investor, in contrast, makes an educated guess that the asset they invest in will increase in value, and not just in price.^{[12]XResearch source}
- For example, an investor invests their money in shares of XYZ corp. because they believe that XYZ corp. is an innovative company that will advance productivity in their industry and benefit the economy as a whole. The speculator buys shares of XYZ to drive up the share price and then immediately sells them off, with no regard for what happens to XYZ after the sale.
3
Grasp why capital gains taxes are controversial. In order to pay capital gains tax, a person has to have assets to sell in the first place. In order to have assets, you have to have money to buy the assets. So capital gains tax inherently rewards those who are already comparatively well off.^{[13]XResearch source}
- For example, a person who makes $37,000 in wages is subject to a 15% tax rate. That level of income—about $700 per week before taxes—is not really sufficient for a person to invest. A person who makes the same amount in capital gains must have enough money to buy and sell assets that net $37,000 in profit—and they pay fewer taxes on that income.^{[14]XResearch source}
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Question
What is the capital gains tax rate?
Darron Kendrick, CPA, MA
Financial Advisor
Darron Kendrick is an Adjunct Professor of Accounting and Law at the University of North Georgia. He received his Masters degree in tax law from the Thomas Jefferson School of Law in 2012, and his CPA from the Alabama State Board of Public Accountancy in 1984.
Darron Kendrick, CPA, MA
Financial Advisor
Expert Answer
There are three capital gains rates, each based on the taxpayer's income. These are 0%, 15% and 20%.
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Question
How much is the capital gains tax on the sale of a home?
Darron Kendrick, CPA, MA
Financial Advisor
Darron Kendrick is an Adjunct Professor of Accounting and Law at the University of North Georgia. He received his Masters degree in tax law from the Thomas Jefferson School of Law in 2012, and his CPA from the Alabama State Board of Public Accountancy in 1984.
Darron Kendrick, CPA, MA
Financial Advisor
Expert Answer
If a gain results on the sale of a personal residence that qualifies for the exclusion, generally, there is no tax. If the sale does not qualify, then regular capital gains rates apply.
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Question
What is capital gains tax on property?
Darron Kendrick, CPA, MA
Financial Advisor
Darron Kendrick is an Adjunct Professor of Accounting and Law at the University of North Georgia. He received his Masters degree in tax law from the Thomas Jefferson School of Law in 2012, and his CPA from the Alabama State Board of Public Accountancy in 1984.
Darron Kendrick, CPA, MA
Financial Advisor
Expert Answer
Capital gain tax is the tax assessed on gains realized from the sale of certain property defined as capital gain property, i.e. personal use property, stocks, bonds, autos, etc.
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