In addition to state and federal taxes on income, there may also be taxes on the increase in value when individually-owned property - a capital asset - is sold. This is commonly referred to as a capital gains tax. While it is taxable annually, the mechanics of calculating capital gains taxes are different than other forms of taxation. On a basic level, consider taking advantage of the lower tax rates on long-term capital gains.
Long-term capital gains rates generally apply when a capital asset is held for more than one year before being sold. Capital assets held for less than one year are subject to short-term capital gains which are taxed at what are called ordinary income tax rates. These tax rates are determined by where you land in the income tax tables for a given year. Typically, when planning for capital gains, the goal is for long-term capital gains treatment because those brackets, at any given level, are usually lower.
Capital gains and losses are generated when a taxpayer sells a capital asset. The IRS defines a capital asset through exclusion: all property owned by a taxpayer is considered a capital asset, except for specific exclusions like inventory, accounts receivable, supplies used in business, and intangible creations like a copyright or musical score. This means that possessions like a home, real property, furnishings, businesses, client lists, collectibles and investments may all be considered capital assets.
If you exchange or sell an asset for more than your basis, you will have either a long-term or short-term capital gain. Basis is the purchase price of the asset plus any commissions, fees, sales taxes paid, and/or improvements to real property made. You can also have a capital loss which occurs when you sell a capital asset for less than your basis. Gains and losses are generally not taxable until that gain or loss is realized by actually selling the asset.
Calculating Capital Gains
There are three basics steps to calculating an individual taxpayer's taxable gain or loss. The process is called "netting" the capital gains in groups. The groups are based, not on the type of capital asset owned (collectibles, stocks, bonds, etc.), but on the holding period for the items.
Please note that determining the amount of capital gain is different than determining the actual amount of taxes owed on that gain - this step comes later. Steps 1 and 2 in the "netting" process below can be calculated in reverse order.
Step 1: Net all long-term capital gains and losses. For example:
In this case, the taxpayer has a long-term capital loss (LTCL) of $150.
Step 2: Net all short-term capital gains and losses.
In this case, the taxpayer has a short-term capital gain (STCG) of $850.
Step 3: The next step is to net these two short and long term numbers together.
After all is said and done, the taxpayer has a short-term capital gain (STCG) of $700.
Results: Here are the different possible outcomes
Once the netting process is complete, the tax treatment can be determined. Short-term capital gains will be added to the amount taxed as ordinary income. Ordinary income is taxed at the rates provided on the federal income tax tables as is income from a job, pension, etc.- this is not preferred. You'll want to avoid any short-term capital gains for the most part, however it can still make sense to accept them in certain situations.
Long-term capital gains, referred to as net capital gains, are not included in the ordinary income tax calculation, and will be taxed at preferred capital gains tax rates. Capital gains tax rates have their own table (similar to federal ordinary income tax rates) and differ depending on how you file your taxes - married filing joint or separate, single, head-of-household, etc.
The capital gains rates are 0%, 15%, or 20% depending on your taxable income on your tax return. Not surprising, there's actually an additional tax that can possibly be added to the capital gains rate, which is referred to as the Net Investment Income Tax (NII Tax) or "Medicare Surtax" at 3.8%. Determining the effective percentage or dollar amount of capital gains paid for your situation can have additional complexities - Please contact us for guidance and consult with a tax professional.
A net capital loss, whether short-term or long-term, can be used to offset up to $3,000 in ordinary income in the year generated. Any additional losses over $3,000 can be "carried forward" into future years. Sometimes, individual taxpayer losses will exceed all capital gains that year, as well as the $3,000 ordinary income offset. This loss, regardless of whether it is short-term or long-term, can be used to offset gains and up to $3,000 in ordinary income in future years. This process can continue until the capital losses are depleted.
Calculating Capital Gains Taxes Owed
Calculating the actual capital gains taxes owed is the final step of the process and it has a very important caveat. That is that capital gains stack on top of ordinary income.
As mentioned previously, the preferred tax rates on long-term capital gains are bracketed, and they apply in the same way that ordinary income tax brackets apply. Also similar to ordinary income taxes, the top marginal tax bracket does not apply to the total amount of realized capital gains. Rather, each tax rate applies to the income within that bracket. However, the capital gains taxes start in the bracket where ordinary income ends. This is referred to as "stacking."
Here are the 2020 capital gain brackets for Married Filing Joint (MFJ), how to read the table, and an example:
The table shows both the income tax rates in the middle column - which most people are used to seeing and hearing - and the preferred long-term capital gains rates in the right column. The taxable income thresholds are shown on the left and represent the starting point for that bracket.
This means that you pay 24% in income tax on each dollar over and above $171,050, all the way until you reach $326,600.
The black bars represent the income amounts that cause an increase in the preferred capital gains rates. Remember that these brackets are different, but we are showing each of the tax types in the same table.
As you can see, even though the income tax rate remains 24% from $171,050 to $326,600 in income, the long-term capital gains rate changes from 15% to 18.8% on each dollar in capital gains that is over $250,000!
Here's an example to illustrate:
Tom and Rita have taxable ordinary income, not including capital gains of $150,000 annually. They also have a long-term capital gains of $500,000 generated by a portfolio reallocation.
The capital gains stack on top of the ordinary income of $150,000. So, a 15% capital gains tax rate will apply to the first $100,000 in capital gains. This $100,000 is the difference between the start of the 18.8% tax bracket, $250,000+, and the $150,000 in ordinary income.
Without the favorable capital gains tax rates, this same $100,000 would be taxed as ordinary income and at their top marginal tax rate of 24%. The capital gains tax rate is a full 9% less than the ordinary income tax rate.
Capital Gain Exclusion on Sale of Primary Residence
If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse. This is known as the Section 121 Exclusion.
In general, to qualify you must meet both the ownership test and the use test. You're eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. The two years do not need to be consecutive.
Although typically used for when capital gains taxed would be owed, and the exclusion not met, installment sales will still qualify for the exclusion. An installment sale may also be used in this situation if you have a gain above-and-beyond your exclusion amount, and want to spread that gain over a number of years.
Another way to think about it is if you lived in your home for a period of several years and then move, you have up to 3 years to sell the home for the exclusion. Generally, you're not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.2
Strategies to Mitigate Capital Gains
Although capital gains rates are preferential when compared to ordinary income tax rates, here are a few tips that may help you reduce or potentially eliminate capital gains:
- Sell capital assets in years when your income will be lower than others. This will put you in the lower tax brackets and therefore can also put you in the lower 0% capital gains bracket. For 2020, you can make up to $80,000 in income (married filing joint) and remain in the 0% capital gains bracket!
- Hold on to your capital assets for at least a year to avoid short-term capital gains if possible.
- Take advantage of the Section 121 Exclusion on your personal residence!
- Consider using an installment sale when selling a piece of property or a business. This will allow you to spread the gain out over a number of years.
- Some capital assets make sense to actually die with! When someone passes away, the beneficiary(ies) of the capital asset gets a "step-up" in cost basis to the fair value on the date of death (appraised value for real property). In cases where an asset is appreciating quickly, an Alternate Valuation Date can be used that instead uses the valuation date 6-months after the date of death. For the beneficiary, his can help eliminate/mitigate capital gains on the asset that would have been realized had the original owner sold or gifted the asset before death.
- If you have multiple "buckets" of assets you draw income from (brokerage account vs. IRA vs. Roth IRA vs. investment property), you may be able to adjust which ones you take from when planning to sell a capital asset or re-balance an investment that will be subject to large capital gains.
- Tax-loss harvest in your brokerage accounts when possible! (try to avoid wash-sales). This takes careful analysis and may make sense to use a professional.
- Group any charitable contributions in order to offset gains that may be produced in a given year (must "itemize" on your tax return).
- Keep track and carry forward your capital losses. Having capital losses provides you with flexibility when needing to make decisions that will involve generating a capital gain in future years.
- Re-balance your brokerage accounts with dividends rather than have the dividends reinvest back into the same investment. Why? This will allow you to purchase more of the under-performers without having to sell shares of the winners and cause capital gains!
- Consider using a Charitable Remainder Trust (CRT) on highly appreciated assets.
The Bottom Line
Understanding taxes is difficult. While taxes are one of the only things certain in life, we can do all we can to mitigate how much we pay within the law. As goes the famous quote from judge Learned Hand:
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
We all have the opportunities to pay less, but it is ultimately our own responsibility to understand how to do so. If you aren't confident navigating tax planning waters on your own, don't hesitate to reach out to a team of qualified professionals.
For more creative planning and investment insights, please visit our blog page: Plan-It
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ in Riverside, California
Refer to Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
Waddell & Reed does not provide tax or legal advice. Waddell & Reed is not affiliated with Ashley Greene and is not responsible for her comments. This information has been obtained from sources believed to be reliable but Waddell & Reed does not guarantee the accuracy or completeness of the information. The information is for educational purposes and it is not financial advice or a specific recommendation of any kind. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions. (09/20)