Navigating capital gains taxes can be like solving a complicated puzzle with rules and strategies that can have a dramatic effect on investment returns. Knowing how to reduce tax liability is crucial for investors.
Capital gains occur when you sell any asset — such as stocks, bonds, private investments, real estate or precious metals — for more than its original purchase price. Your tax liability will depend upon multiple factors including filing status and how long you owned the asset in question.
Short-Term and Long-Term Gains
Capital gains occur when you sell property, stocks or other assets for more than their total cost basis. Your tax liability depends on how much was gained upon sale; your overall tax rate; and the length of time held before selling.
If you purchase and then sell an asset within one year, any profits are classified as short-term capital gains and are taxed similarly to ordinary income based on your household’s federal income tax bracket. On the other hand, holding it longer than one year allows your profits to become long-term and will be subject to a lower, longer-term capital gains rate of taxation.
As with any type of asset, keeping records detailing purchases and sales are vitally important when accounting for capital gains or losses. Accurate record keeping helps calculate gains or losses more precisely and accurately.
Depreciation Deductions
Real estate investors may be able to reduce their capital gains tax liability with depreciation deductions, which reflect the gradual deterioration of property over time. Unfortunately, depreciation deductions could increase overall taxable capital gain if they sell the property later because sale prices are calculated based on original purchase cost plus expenses such as shipping fees and closing costs.
When selling a personal residence, the IRS exempts up to $250,000 of capital gains taxes from being due – or $500,000 for married filing jointly). But this same rate of tax applies if selling other real estate that’s been depreciated such as rental properties or business assets.
In addition, special “like-kind exchange” rules may help you avoid capital gains tax when trading business property of similar type for another. But this requires taxpayers to identify replacement property within 45 days after selling off the old one.
Tax-Advantaged Accounts
An effective investment portfolio includes tax-advantaged accounts such as 401(k) plans at work, 403(b) plans at nonprofits and government agencies, I Bonds (savings bonds), etc. Not only can these vehicles help you meet retirement or education savings goals but they are also invaluable when it comes to mitigating capital gains tax liabilities.
Every time you sell an asset that cost more than its current selling price, a taxable capital gain occurs. This applies to stocks, bonds, options contracts, real estate and precious metals – although you can reduce this difference between selling price and cost basis by employing strategies such as tax loss harvesting or charitable giving.
Investors may use capital losses from sales of securities as tax credits in future tax years – up to $3,000 annually – but cannot carry them back into prior years due to what’s known as the wash sale rule.
Offsetting Losses
As Ben Franklin famously stated, nothing in life is certain except death and taxes – but one way you can lower your capital gains tax bill by offsetting taxable gains with deductible losses is offsetting them with tax losses.
Your taxable portion of profit is the difference between what you received when selling or exchanging a capital asset and its “basis” – what it cost – when selling or exchanging. Determining this can sometimes be straightforward, while other times requiring meticulous recordkeeping and diligence.
The IRS allows you to apply your net short-term and long-term losses against capital gains of similar nature, as well as ordinary income (such as wage earnings) up to an annual total of $3,000; any unused losses can carry over to future years. For more information, see IRS guidance on capital gains taxes which includes a worksheet. For personalized advice tailored specifically for you consult a qualified financial planner.