Whether you are handling your personal finances or doing small business accounting, it is important to understand capital gains taxes. Put simply, you must pay capital gains taxes anytime you sell an asset for profit. However, there are many factors that can influence how much you owe the IRS. Below are a few important terms that provide a glimpse into the world of capital gains taxes.
Capital Gains Tax
This is the tax applied anytime you sell a capital asset for profit. It’s important to note that the tax is applied only when you sell or make a profit from a capital asset, not during the years it is accruing value. For example, if you bought stock for an initial investment of $100 and the value of the stock increased by $200 each year, you would not owe tax on the $200 profit each year. However, if you sold the stock after 10 years, for $2,100, you would owe capital gains tax on the $2000 profit that you earned over the life of the investment.
Capital Gains Tax and Business Income
When you earn a profit from selling an asset that is considered inventory of your business, it is considered business income, rather than a capital gain. For example, if your business is buying and selling antiques, the money you earn in profit is taxed as business income, not capital gains.
The IRS defines a capital asset as “most property you own for personal use or own as an investment.” Most common capital assets are real estate, stocks, bonds, options, and valuable collectibles. Essentially, anything that can accrue a profit over time can be considered a capital asset.
When the sales price of a capital asset is higher than your purchase price, you have a capital gain. For example, if you buy a piece of art for $50, keep it for 30 years, and then sell it for $3,000, you would have a capital gain of $2,950.
When the selling price is less than the purchase price, you have a capital loss. For example, if you buy shares of stock for $1,000 and after 10 years, you sell them for $100, you would have a capital loss of $900.
Net Capital Gains
This is a very important term because you only pay taxes on your net capital gains, which is the total amount of capital gains minus any capital losses. For example, if you sell shares in two mutual funds – one for a $5,000 profit and the other for a $5,000 loss – the amount of the loss offsets the profit so your net capital gain would be zero and you would not owe capital gains tax.
Short-Term Capital Gains
Gains on an asset that you have held for less than one year are short-term capital gains. To lower your capital gains tax, avoid short-term investments as they are taxed at a higher rate than long-term capital gains.
Long-Term Capital Gains
Gains on an asset that you have had for more than one year are long-term capital gains. These are taxed at a more favorable rate short-term term capital gains.
For most people, their residence is their most valuable asset. The tax code allows homeowners to avoid some, if not all, of the capital gains tax on the sale of their primary residence provided that certain criteria are met.
Capital Gains Tax Rates
Capital gains taxes are applied at different rates, depending on your income level. Those with a lower income level pay a lower rate of capital gains tax. The rate increases as income levels rise.