Capital Gains Tax
If you’ve had a successful year of investing, you’ve likely sold a few stocks and cashed out at a net profit. While those gains might feel good in your wallet right now, it’s important to remember that you’ll likely have to hand over some of your earnings in taxes when April rolls around. Today we’ll be talking about what capital gains tax is and how it works.
What Are Capital Gains?
A capital gain is defined simply as the increase in the value of an asset. The asset can be a stock, a car, or even a house. When you sell an asset that has increased in value, you have realized that capital gain and will be subject to capital gains tax. The rules on what sales incur capital gains taxes and how much those capital gains will be can be more specific in certain situations, which is why it’s important to consult a CPA or other financial professional to make sure you’re paying the correct amount in taxes.
Looking for some extra tax tips? Check out our article on Stocks and Taxes!
Capital Gains Tax Rates
There are two types of capital gains you can create when you sell an asset for a profit: short-term capital gains and long-term capital gains. A short-term capital gain is created when you hold the asset for one year or less before selling. A long-term capital gain is created when you hold the asset for more than a year before selling. This distinction is important because short-term capital gains and long-term capital gains are taxed differently.
Short-term capital gains are taxed as regular income. For example, if you made $50,000 this year and you recognized a $5000 capital gain from the sale of stocks you held for one year or less, your taxable income becomes $55,000. Basically, the tax rate for any short-term capital gains you realize will be equal to your marginal tax bracket rate.
Long-term capital gains are taxed at specific rates predetermined by the IRS based on your income. Here are the long-term capital gains tax rates for single filers for 2021:
- 0% for single filers with an income up to $40,400
- 15% for single filers with an income between $40,400 and $445,850
- 20% for single filers with an income above $445,850
Capital gains tax rates for heads of household and married couples are slightly different and can be found on the IRS website.
Do Losses Lower My Capital Gains Tax?
In short, yes. When you sell an asset that has decreased in value, you have recognized a loss. Losses can usually be used as a deduction against your taxable income, thus lowering the amount you’ll pay in taxes. For example, if you made $50,000 this year and recognized a $5000 loss from the sale of stocks, your taxable income becomes $45,000, which will lower your total tax payment. There are, however, special rules in place to keep people from taking advantage of the tax benefits provided by losses, which brings us to the wash-sale rule.
A wash sale occurs when you recognize a loss by selling an asset that has decreased in value, and then buy back the asset or a similar asset within 30 days of that sale. The wash-sale rule is a rule from the IRS that prevents you from taking a tax deduction for the loss that you realized in a wash sale.
The wash-sale rule is meant to keep people from cheating the tax system. If the wash-sale rule was not in place, you could look at every stock you own that has gone down since you bought it, sell each one, and buy it back immediately. This would create a bunch of losses that you could use as tax deductions, but it wouldn’t be fair since you didn’t really sell for a loss; you just sold and bought back in shortly after. In order to realize a real loss that you can use as a tax deduction, you have to “play fair” and only sell assets on which you truly intend to take a loss.
While taxes are very predictable and shouldn’t be anything to be afraid of, many people are blindsided by their tax payments every year. In order to prevent yourself from being taken by surprise, make sure you keep track of your realized gains so you can have an accurate read on your capital gains tax requirements for the year!