Let’s start by saying that, under the right conditions, nearly everyone can be subject to paying capital gains tax – that is, anyone who owns a capital asset.
According to the IRS, “Almost everything you own and use for personal or investment purposes is a capital asset. Examples include a home, personal-use items like household furnishings, and stocks or bonds held as investments.” You could incur capital gains tax on your real estate assets, land, vehicle, electronics, jewelry, stocks, art, collectibles, business holdings… you get the idea.
Today, markets are hitting all-time highs, and your investments might have significantly increased in value since their purchase. You may be thinking of selling these high-performers – either for a much-needed cash injection, to make a new purchase, or to rebalance your portfolio.
If you manage to sell your investment for a price higher than your original purchase price (also known as your basis), you will have realized a capital gain. If your sales amount is lower than your basis, this constitutes a capital loss.
There are two types of capital gains, related to the length of time you have owned a capital asset or stock. If your asset appreciated and you have owned it for less than a year, this is considered a short-term capital gain. If you have held onto an asset for longer than a year, this is considered a long-term capital gain.
If you decide to sell a stock or any other capital asset you have owned for longer than one year (generally count from the day after the day you acquired the asset up to and including the day you disposed of the asset), you may be subject to long-term capital gains tax. At the time of writing this article, federal long-term capital gains tax rates vary, depending on household income and, at times, the type of asset you are selling.
If, however, you sell an appreciated stock after owning it less than a year, you may need to pay short-term capital gains tax, the rate of which is the same as ordinary income tax rates.
Long-term capital gains tax rates tend to be lower than short-term or ordinary income tax rates, which is why holding onto your asset for more than a year makes a lot of sense from the tax perspective, most of the time.
What is Capital Gains Tax?
In order to learn how to minimize or avoid capital gains taxes, it is important to understand the terms “capital gain” and “capital gains tax”, and how the tax is calculated.
IRS Topic 409 on Capital Gains and Losses states: “When you sell a capital asset, the difference between the adjusted basis in the asset [i.e. the amount you originally purchased your asset for] and the amount you realized from the sale is a capital gain or a capital loss”.
A “Capital Gains Tax” is an amount you are obligated to pay on your capital gain from selling stocks, bonds, or any other capital asset.
Any time you trade or sell an investment for more than your basis (your basis is the amount you originally paid for it), you will have a capital gain – but you will not always be subject to capital gains tax.
For example, let’s say you bought a stock for $30 (your basis) and then sold it later for $42. You have realized a $12 capital gain. You may have to pay capital gains tax on the $12 gain, but not the entire $42 sales price.
The sale of an appreciated capital asset makes the capital gain “realized”. If you hold on to an appreciated asset and choose not to sell, the capital gain remains “unrealized.”
So, How do Capital Gains Taxes Work?
Capital gains can be subject to state and federal taxes.
Generally, if you hold [a stock or any other capital] asset for more than one year before you dispose of it, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term.
Capital gains are taxed the year an asset is sold, regardless of when an asset appreciated, and the capital gain occurred.
Unrealized, accumulated capital gains are usually not considered to be taxable income. For example, if you purchased an asset (such as a share of stock) for $30 ten years ago, and it is now worth $42, you may have to pay a long-term capital gains tax on the $12 gain, but only if you decide to sell the stock, and only on the year of the sale. This is called “taxation upon realization”.
The benefits of taxation upon realization are obvious. No tax is paid until a sale is made; the price the asset is sold for minus the basis determines the amount of capital gain (or loss).
Another benefit of taxation upon realization is that the investor is rewarded for holding onto their capital assets for as long as possible, which is at times referred to as a “lock-in effect.”
Long-Term Capital Gains
Long-term capital gains are the result of holding onto a stock, mutual fund or other capital assets for more than a year, of course – if the stock or asset appreciated in the meantime. Investors are incentivized to hold onto a capital asset for at least one year in order to benefit from a lower long-term capital gains tax rates.
Short-Term Capital Gains
Investments held for less than a year and sold for a profit are subject to short-term capital gains taxes. Short-term capital gains tax rates are the same as ordinary income tax rates. Your ordinary income tax rate depends on the entirety of your household’s taxable income.
Even small gains are subject to ordinary income tax rates, and a larger capital gain may put you into a higher tax bracket.
Of course, it is not always possible to wait an entire year before making a sale – many aspects beyond tax consequences should be considered when selling an asset.
So, What are My Options for Avoiding Capital Gains Tax on Stocks?
Thankfully, tax law and IRS regulations give us several methods for reducing, deferring, or eliminating capital gains taxes on stocks or other capital assets. Here are a few approaches you can take to lower your capital gains tax bill:
One: Using Tax Losses or Loss Harvesting
A well-known strategy for reducing capital gains is to sell other investments at a loss and use those capital losses to balance the gains for tax purposes. If we make a capital gain of $10, and a capital loss of $10, the net effect is zero – and no taxes are owed.
However, utilizing capital losses is the least beneficial of all the options in this article. Using capital losses literally means you have to lose money on one stock in order to avoid paying income taxes on another.
This method is often referred to as loss harvesting, where you sell shares at a loss on purpose, to balance the gains on profitable sales and then distribute this capital elsewhere.
Losses give you the chance to offset gains and balance your portfolio while paying a lighter tax bill.
Selling ‘down’ investments at a loss and reporting the loss on your tax return could help you offset taxes from the sale of better-performing stocks.
Two: Spreading Capital Gains Over Several Years
Another option for lowering your capital gains taxes can be to sell the stock or asset over several tax years – this can help ease the tax burden.
For example, you might sell a part of an investment at the end of the year 2022, then another part in 2023, and the final portion at the start of 2024. The sale will be concluded in a little over twelve months, but tax liability will be dispersed over three tax years.
However, it is crucial to remember that waiting to sell investments or assets involves risks. The tax benefits of holding onto those assets may not outweigh the benefits of a good sale.
Three: Donating Stocks or Assets Instead of Cash
If you are planning on making a charitable contribution, why not donate your stocks?
You could sell your high-performing stocks, pay taxes on them, and then donate the money to a charity and finally claim a charitable contribution deduction (if you’re eligible).
Or, you can make this entire process much simpler by donating stocks instead of money. This way you avoid paying capital gains taxes, still get the tax deduction, and the charity or other non-profit organization of your choice still receives their donation. In addition, the charity may not have to pay any capital gains taxes when they sell the stock.
What About No Tax Until 2026? And an Even Lower Capital Gains Tax?
Besides tax-loss harvesting, donating, and spreading your earnings over several tax years, there are strategies that offer large tax savings!
Qualified Opportunity Zones
Qualified Opportunity Zones (QOZ) are by far the most advanced strategy mentioned in this article. If you qualify and are patient, a QOZ will let you defer, reduce AND eliminate capital gains taxes, while simultaneously helping create new jobs and increase economic growth in low-income areas.
Here’s how it works:
– If certain conditions are met, investing your capital gain in a Qualified Opportunity Zone (QOZ) by December 31st 2021 can DEFER your federal (and at times, state) capital gains tax until 2026.
– You can also LOWER your federal (at times state) capital gains tax by 10% if you keep your gain in the QOZ for a period of 5 years.
– You can also ELIMINATE any federal (at times state) capital gains taxes on the APPRECIATION of the QOZ if you leave your funds untouched for 10 years.
A Qualified Opportunity Zone will NOT eliminate your initial capital gain, but it will defer or reduce capital gains taxes for you, plus – there is always the possibility that your share in the QOZ will appreciate in value, and there will be no capital gains tax on THAT appreciation.
If you’re interested in investing, you have 180 days from the date the capital gain is recognized for tax purposes, with a hard stop on December 31st, 2021, which is when the strategy is set to expire (though many experts are optimistic that it will be extended).
FAQ about Capital Gains Taxes:
How do I calculate my capital gains rates?
The actual taxes you will pay on your capital gains depend on a wide variety of factors: your household income for the year, filing status, the length of time you have owned a stock or capital asset before selling, any deductions you are eligible for, any capital losses you will be claiming, any tax reduction strategies or tax cuts you will be implementing… in a word, there is no easy answer!
However, a basic calculation can be the amount you sold your capital asset for, minus any sales fees, minus what you originally paid for the asset. If you bought the asset or stock for $100, sold it for $150 but incurred $10 in transaction fees, your capital gain will be $40.
To further calculate your capital gains tax rate for the $40, you would need to know your total household income, whether this was a long or short-term gain and the type of capital asset you sold. It’s best to leave these calculations to the experts and let a tax advisor calculate whether you’ll owe capital gains tax.
Does a net capital gain count as income?
According to the Internal Revenue Code: The term “net capital gain” means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss for the year. The term “net long-term capital gain” means long-term capital gains reduced by long-term capital losses including any unused long-term capital loss carried over from previous years. And yes, your capital gain is a type of income to you.
Is the term capital gains tax separate from income tax?
Capital gains are a type of income tax. Capital gains tax is due as a result of the sale of an appreciated asset – such as a stock that is worth more now than it was when you bought it. This appreciation in value is income to you. However, different rules and rates apply to capital gains taxes and other types of income taxes.
What is considered taxable income?
According to the IRS, income can come in many forms – employee compensation, certain fringe benefits, business income, income from investments, tips, partnership income, income from virtual currencies, rental income, royalties… the list is very long and even the IRS admits it is not all-inclusive.
Two basic forms of taxable income are active income (such as performing surgery, preparing a tax return, cooking a meal – activities you perform for an employer, as a self-employed individual or business owner); the second type of income is passive income. This second type of income includes investment income, rental income (unless you have professional real estate status), or income from a partnership where you are not an active member. A lot of capital gains come from passive income.
Do I have to pay capital gains taxes if I have capital losses?
Maybe. This depends on many factors, including the amount of gains vs losses in any given tax year. Intentionally using capital losses to offset capital gains (from investment income, stocks, mutual funds, etc.) is often referred to as tax loss harvesting.
How low does my income have to be to avoid capital gains tax?
This depends on your filing status. As of writing this article, single taxpayers as well as married taxpayers filing separately who earn under $40,400 pay a 0% long-term capital gains tax. The threshold is $80,800 for taxpayers who are married filing jointly and $54,100 if filing as head of household.
What is Net Investment Income Tax?
Net Investment Income Tax, or NIIT, is a 3.8% tax that is applied to net investment income of individuals earning over a certain threshold. The tax is applied in addition to your capital gains tax rate. To be subject to this additional tax, individuals (or estates and trusts) must have net investment income and modified adjusted gross income over a certain threshold. As of writing this article, the income thresholds are: $250,000 and over for married filing jointly; $125,000 and over for married filing separately; $200,000 and over for single taxpayers and heads of household (with qualifying person); $250,000 and over for widows and widowers with a dependent child.
There are some exceptions and additional considerations in certain cases, such as when selling a personal residence.
I’m selling my home. Can I sell it below fair market value to avoid capital gains tax?
No! At times supply may be much higher than demand, and you may be forced to somewhat reduce the price of your home. This is understandable. However, selling your home below fair market value on purpose (to a relative or to avoid taxes) will be a major red flag for the IRS and will lead to negative consequences for both you AND the buyer.
Bottom line
You have to pay your tax bill. There are, however, various strategies that will allow you to pay less in taxes – even as low as 0%. If you are a business owner, a high-income earner, entrepreneur or investor, it makes sense to invest in tax reduction planning so you can pay the legal minimum in taxes – either by spreading out your gains, participating in a Qualified Opportunity Zone, or donating stocks or capital assets to a charity instead of cash.
If you need any guidance on your tax situation and how you can make the best of it, we can put you in touch with our experienced Las Vegas Tax Reduction Strategist!
Contact us for a free consultation! We are here for you.