What Is Capital Gains Tax?

What Is Capital Gains Tax? article image.

The capital gains tax is a tax you may have to pay if you sell a capital asset for a profit. Capital assets could include stocks, bonds, property, vehicles, collectibles, antiques, cryptocurrencies and businesses. The capital gains tax rate is lower than many people's ordinary income tax rate, which may be an incentive to make long-term investments.

What Is Capital Gains Tax?

The capital gains tax only applies to profits from capital assets when you actually realize a gain, not when an asset simply rises in value.

For example, if you buy a stock for $100 and its value increases to $250, you have $150 in unrealized gains. You don't have to pay taxes on the stock's increased value because you haven't made any money yet—the stock might even drop in value before you sell it.

Capital gains and losses are realized when the asset is sold. If you sell an asset for more than you bought it for, you could then have to pay capital gains taxes on the difference between the asset's cost basis (generally, the purchase price) and the sale price. Sticking with our previous example, if you sell the stock when it's worth $250, you realized $150 in capital gains and may have to pay taxes on the $150 profit.

Capital gains can be considered either short-term or long-term depending on whether you held the asset for at least a year before selling it. Short-term capital gains are taxed like ordinary income. Long-term capital gains have their own tax rate, which will be lower for many people. (Different rules apply if you inherited or were gifted the asset, however.)

Short-Term Capital Gains Tax Rates for 2021

If you purchase an asset and then sell it within a year, you have to use the short-term capital gains tax rate—which is the same as the tax rate charged on your ordinary income. The amount you owe depends on your tax filing status and your taxable income, which is less than your adjusted gross income (AGI) and may be much less than your annual gross income.

Short-Term Capital Gains Tax Rates
RateSingleMarried, Filing Jointly and Qualifying Widow(er)Married, Filing SeparatelyHead of Household
10%Up to $9,950Up to $19,900Up to $9,950Up to $14,200
12%$9,951 - $40,525$19,901 - $81,050$9,951 - $40,525$14,201 - $54,200
22%$40,526 - $86,375$81,051 - $172,750$40,526 - $86,375$54,201 - $86,350
24%$86,376 - $164,925$172,751 - $329,850$86,376 - $164,925$86,351 - $164,900
32%$164,926 - $209,425$329,851 - $418,850$164,926 - $209,425$164,901 - $209,400
35%$209,426 - $523,600$418,851 - $628,300$209,425 - $314,150$209,401 -

$523,600

37%$523,601 and up$628,301 and up$314,151 and up$523,601 and up

Source: IRS

Long-Term Capital Gains Tax Rates for 2021

The long-term capital gains rate also depends on your filing status and taxable income. For many people, the long-term capital gains tax rate will be lower than their short-term tax rates.

Long-Term Capital Gains Tax Rates
RateSingleMarried, Filing Jointly and Qualifying Widow(er)Married, Filing SeparatelyHead of Household
0%Up to $40,400Up to $80,800Up to $40,400Up to $54,100
15%$40,401 - $445,850$80,801 - $501,600$40,401 - $250,800$54,101 - $473,750
20%$445,851 and up$501,601 and up$250,801 and up$473,751 and up

Source: IRS

How to Calculate Capital Gains Tax

Making enough money that your income reaches into a new tax bracket doesn't automatically increase how much you pay on all your taxable income—ordinary or capital gains. Refer to the tables above and follow along with our example to see how the different tax rates and brackets can apply.

Say you're single and have $35,000 in taxable income from your salary plus $2,000 in short-term capital gains from selling stocks and $5,000 in long-term capital gains from additional stock sales.

Your salary and short-term capital gains are treated as ordinary income. So, you'll pay 10% on the first $9,950 and 12% on the remaining $27,050.

You then calculate your long-term capital gains taxes separately. You have a total of $42,000 in taxable income from your salary, short-term and long-term capital gains. As a result, you pay 15% on the $1,600 in long-term capital gains that's over the $40,400 threshold. The remaining $3,400 falls in the 0% tax bracket, so you don't pay any capital gains taxes on that amount.

There are also many rules that can impact your individual tax situation and complicate the calculations:

  • Subtract capital losses from gains.You only pay taxes on your net capital gains, which is your capital gains minus your capital losses. Even if you came out ahead with some investments, losses can wipe out your tax liability.
  • You can deduct excess capital losses. If you have more capital losses than gains, you can deduct up to $3,000 ($1,500 for married filing separately) from your ordinary income. You can carry excess losses to the next year.
  • Capital gains can increase your AGI. Long-term capital gains don't impact your ordinary income tax bracket. But they can increase your AGI, which may affect your eligibility for tax deductions, credits and other benefits.
  • Certain capital assets have special rules. For example, net capital gains from collectibles are taxed at 28%. And, you may be able to exclude up to $250,000 in capital gains from the sale of your home—$500,00 if you're married and filing jointly.
  • High-income taxpayers may pay more. An additional 3.8% net investment income tax (NIIT) could apply to high-income households.
  • The cost basis of an asset can change. It may decrease if the asset depreciates or increase if you paid purchase fees or made improvements. The cost basis can also differ depending on whether you bought, were gifted or inherited the asset.
  • You may have state capital gains taxes. Both the charts above show federal tax rates. Your state may also have separate tax rates for ordinary income and capital gains.

Fortunately, tax software—including options that are free for many taxpayers—will do the calculations for you. Still, you may want to contact a tax professional before making a major financial decision if you're unsure how selling a capital asset could impact your tax situation.

How to Reduce Capital Gains Tax

While long-term capital gains tax rates are often lower than ordinary tax rates, you can look for ways to further reduce your tax bill. Here are a few ideas:

  • Hold assets for at least a year. This qualifies you for the long-term capital gains rate.
  • Invest in tax-advantaged retirement accounts. Certain types of 401(k) accounts and individual retirement accounts (IRAs) allow you to avoid paying taxes on money that's deposited until you withdraw the funds from the account.
  • Donate capital assets. If you donate an asset rather than selling it and donating the proceeds, you can still receive an itemized tax deduction—and you don't have to pay taxes on the profits.
  • Realize capital losses. Determine if realizing capital losses to offset gains makes sense this year.

The Bottom Line

Understanding the difference between short- and long-term capital gains taxes can be important when you're making investment decisions. If you can take advantage of lower capital gains tax rates, you may be able to pay less taxes on your earnings than your ordinary income. There may also be opportunities to realize capital gains without paying any capital gains tax.

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