Capital Gains Tax 101 (2024)

Although marginal tax brackets have changed over the years, historically the maximum tax on ordinary income has almost always been significantly higher than the maximum rate on capital gains.

Not all capital gains are taxed according to the standard 0%/15%/20% schedule. Here are some exceptions where capital gains may be taxed at higher rates than 20%:

• Gains on collectibles, such as artworks and stamp collections, are taxed at a maximum 28% rate. Currently, it is unclear whether the IRS could ultimately treat some NFTs as collectibles for tax purposes.
• The taxable portion of gain on the sale of qualified small business stock (Section 1202 stock) is also taxed at a maximum 28% rate.
• The portion of any unrecaptured Section 1250 gain from selling Section 1250 real property is taxed at a maximum25%rate.

How Do You Calculate Capital Gains on the Sale of Property?

The amount of capital gains you pay on the sale of property depends on whether the property is your principal residence (and how long you lived there) or a rental or investment property.

Due to a special exclusion, capital gains on the sale of a principal residence are taxed differently than other types of real estate. Basically, if you sell your main home and have a capital gain, you can exclude up to $250,000 of that gain from your income, provided you owned and lived in the home for two years or more out of the last five years. (The years don't have to be consecutive.) For married couples filing jointly, the exclusion is $500,000.

Let's say you and your spouse purchased your home for $400,000 and lived in it for seven years. If you now sell it for $675,000, your profit is $275,000, which means that you won't owe the IRS any capital gains taxes on the sale, given the $500,000 exclusion for married couples.

However, a rental property doesn't qualify for the same exclusion on capital gains taxes as a primary residence does. If you sell a rental property that you've owned for more than a year and for a higher price than you paid for it, the IRS requires that you pay a 25% depreciation recapture on the portion of your profit that you previously deducted as depreciation. You'll also have to pay long-term capital gains on the profit balance at a rate of 0%, 15%, or 20%, depending on your income—assuming you have owned the property for more than a year. If you've owned if for less time than that, any profit you make will be taxed at your ordinary income tax rate.

It is possible to reduce your capital gains tax on the sale of a rental property if you plan ahead—for example, by establishing it as your primary residence for at least two years prior to any sale. Consult a tax expert for advice on other methods.

Net Investment Income Tax

In addition to regular capital gains tax, some taxpayers are subject to the net investment income (NII) tax. It imposes an additional 3.8% tax on your investment income, including your capital gains, if your modified adjusted gross income (MAGI) is greater than:

• $250,000 if married filing jointly or a qualifying widow(er) with a child
• $200,000 if single or a head of household
• $125,000 if married filing separately

How to Calculate Long-Term Capital Gains Tax

Most individuals figure their tax (or have pros do it for them) using software that automatically makes the computations. You can also use a capital gains calculator to get a rough idea. Several free calculators are available online. Still, if you want to crunch the numbers yourself, here's the basic method for calculating capital gains tax:

1. Determine your basis. The basis is generally the purchase price plus any commissions or fees you paid. The basis can be adjusted up or down for stock splits and dividends.
2. Determine your realized amount. This is the sale price minus any commissions or fees you paid.
3. Subtract the basis (what you paid) from the realized amount (what you sold it for) to determine the difference. This is the capital gain (or loss).
4. Determine your tax. If you have a capital gain, multiply the amount by the appropriate tax rate to determine your capital gains tax for the asset (remember that tax rates differ depending on your taxable income and how long you held the asset before you sold it). If you have a capital loss, you may be able to use the loss to offset capital gains.

How to Minimize or Avoid Capital Gains Tax

There are a number of ways to minimize or even avoid capital gains taxes. Here's a look at five of the more common strategies:

1. Invest for the Long Term

You will pay the lowest capital gains tax rate if you find great companies and hold their stock long-term. Of course, this is easier said than done. A company’s fortunes can change over the years, and there are many reasons why you might want or need to sell earlier than you originally anticipated.

2. Take Advantage of Tax-Deferred Retirement Plans

When you invest your money through a retirement plan, such as a 401(k),403(b), or individual retirement account (IRA), it will grow without being subject to immediate taxes. You can also buy and sell investments within your retirement account without triggering capital gains tax.

In the case of traditional retirement accounts, your gains will be taxed as ordinary income when you withdraw money, but by then, you may be in a lower tax bracket than when you were working. With Roth IRA accounts. However, the money you withdraw will be tax-free—as long as you follow the relevant rules.

For investments outside of these accounts, it might behoove investors nearretirementto wait until they stop working to sell. If their retirement income is low enough, their capital gains tax bill might be reduced, or they may be able to avoid paying any capital gains tax. But if they’re already in one of the “no-pay” brackets, there’s a key factor to keep in mind: If the capital gain is large enough, it could increase their total taxable income to a level where they would incur a tax bill on their gains.

3. Use Capital Losses to Offset Gains

If you experience an investment loss, you can take advantage of it by decreasing the tax on your gains on other investments. Say you own two stocks, one worth 10% more than you paid for it, while the other is worth 5% less. If you sold both stocks, the loss on the one would reduce the capital gains tax that you would owe on the other. Obviously, in an ideal situation, all of your investments would appreciate, but losses do happen, and this is one way to get some benefit from them.

If your capital losses exceed your capital gains, you can use up to $3,000 of it to offset ordinary income for the year. After that, you can carry over the loss to future tax years until it is exhausted.

4. Watch Your Holding Periods

If you are selling a security that you bought about a year ago, be sure to find out the trade date of the purchase. Waiting a few days or weeks to qualify for long-term capital gains treatment might be a wise move as long as the investment's price is holding relatively steady.

5. Pick Your Cost Basis

When you’ve acquired shares in the same company or mutual fund at different times and prices, you’ll need to determine your cost basis for the shares you sell. Although investors typically use thefirst in, first out (FIFO)method to calculate cost basis, there are four other methods available:last in, first out (LIFO),dollar-value LIFO,specific share identification, and average cost(only for mutual fund shares).

If you’re selling a substantial holding, it could be worth consulting a tax advisor to determine which method makes the most sense.

The Bottom Line

Although the tax tail should not wag the entire financial dog, it’s important to take taxes into account as part of your investing strategy. Minimizing the capital gains taxes you have to pay—for example, by holding investments for more than a year before you sell them—is one easy way to boost your after-tax returns.