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Understanding the Capital Gains Tax and How to Calculate It

April 25, 2022
7
min

Capital gains build wealth and grow assets, these are taxed differently depending on a number of factors like how long the asset was owned and how much the taxpayer earns.

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Everyone loves it when a stock or other asset gains in value and is sold for a profit. But not all of that profit goes into an investor's pocket. The U.S. imposes taxes on those capital gains. Here’s a look at what capital gains taxes are, the current capital gains tax rate, and some exceptions to the tax liability.

What is the capital gains tax?

The capital gains tax is a federal tax levied against any profit on the sale of capital assets. It is levied separately from income tax on normal wages. 

Most taxpayers are already paying federal taxes on their wages, typically through automatic withholdings from their paycheck. However, if they are also making money by trading stock, that’s additional income and, from the government's perspective, should be taxed accordingly.

This means that if someone buys a stock, then later sells it for a profit, they’ll be expected to pay taxes on that profit — or the difference between what they paid and what they sold that capital asset for. (In some instances, if someone sells an asset for less than they paid, they may be able to claim a loss instead.)

The capital gains tax is designed to catch taxable events (like the sale of stock) that would otherwise be excluded from typical federal income tax. 

Capital assets are items that, if sold for a profit, will trigger a capital gains taxable event. Examples of these types of assets include:

  • Various securities, such as shares of stocks and mutual funds
  • Real estate property, such as land or a home
  • Vehicles and machinery
  • Trademarks and patents held
  • Collectibles and art

Nearly anything that is of significant value to investors, and can be sold for more than it was bought for, is considered a capital asset.

How does the capital gains tax work?

In order to determine whether capital gains taxes are due, first figure out whether the sale of the item was at a higher or lower cost than the price paid for the item. 

The amount the item was sold for is an asset’s amount realized. The amount it was bought for, including any eligible related expenses, is its adjusted basis. 

For example, if an individual buys a classic car for $15,000 and spends $10,000 to fix it up, the car’s adjusted basis (or the amount it was bought for) is considered to be $25,000. If they later sell that car for $45,000, they will likely owe capital gains tax on the difference, or $20,000.

When is capital gains tax paid? 

Capital gains tax is due when the owner sells an asset for a profit. In some cases, individuals may pay capital gains tax when it comes time to file taxes. In other cases, they would pay taxes right away, or in quarterly installments.

Following a sizable gain from the sale of an asset, a taxpayer may be expected to begin making quarterly tax payments to the IRS, rather than waiting until the end of the year to do so. 

Quarterly tax payments are generally expected if, after the capital gains taxable event, one expects to owe $1,000 or more on their taxes for the year, and if their new tax burden is more than either 100% of last year’s taxes due or 90% of their expected taxes for this year.

Short-term vs. long-term capital gains tax

There are two categories of capital gains: short-term capital gains and long-term capital gains. Each is taxed differently.

Short-term capital gains (STCG) are incurred when an item that is held for one year or less is sold for profit. If someone purchases shares of a stock and then sells them a few months later, they’ll be taxed at the short-term capital gains tax rate.

Long-term capital gains, on the other hand, are incurred when an item that is held for longer than a year is sold for profit. These gains are taxed at the long-term capital gains tax rate, which is lower than short-term gains.

Capital gains tax rates

Gains on short-term capital assets—those held for a year or less— are taxed as ordinary income. This means that the gain is added to a taxpayer’s total taxable income for the year, and the combined income is taxed based on the standard, graduated tax brackets into which that income falls.

Gains on long-term capital assets—those held for more than a year—on the other hand, are taxed differently. An individual would tally up all their long-term capital gains throughout the year to figure out their net capital gain. That is taxed at between 0% to 28%, depending on the individual’s income and the type of asset.

Net capital gain (or loss) is one’s total long-term capital gains, minus any capital losses, both long- and short-term. (Short-term capital gains are counted as ordinary income.) If that is positive, the individual posts a net capital gain for the year. If it’s negative, a net capital loss.  

The individual would have to pay taxes on net capital gains. Here are the 2022 tax rates for net capital gains:

If filing status is… And income is… The capital gains tax rate is…
Single Less than or equal to $40,400. Less than $80,800 (married filing jointly or qualifying widow(er)s) 0%
Single More than $40,400 but less than or equal to $445,850 15%
Head of household More than $54,100 but less than or equal to $473,750 15%
Married filing separately More than $40,400 but less than or equal to $250,800 15%
Married filing jointly or qualifying widow(er)s More than $80,800 but less than or equal to $501,600 15%
Higher than the limits above 20%

Exceptions to capital gains tax rates

As the chart above shows, the typical maximum capital gains tax rate is 20%. However, there are several exceptions to those capital gains tax rate rules. Here are the three primary ones:

  • If you sell section 1250 real property (which could be a house, building, or lot), a portion of the gain may be taxed at a maximum of 25%.
  • If you sell collectibles (art, coins, etc.), your capital gains tax rate is a maximum of 28%. 
  • If your taxable gains come from selling qualified small business stock (section 1202) your capital gains tax rate is a maximum of 28%. 

There are many exceptions to capital gains made on owner-occupied homes. 

All homeowners are eligible for a $250,000 capital gains exemption following the sale of their home, as long as that home has been used as their primary residence for at least two out of the last five years. (For eligible active duty military members, this can be extended to two out of the last 10 years.) That eligible amount doubles for married couples filing a joint tax return. This means that a couple could be exempt from up to $500,000 in capital gains from the sale of their property, as long as they lived in the home for the required period of time.

Additionally, the capital gains recognized from the sale of a real property can be deferred using what’s called a 1031, or Like-Kind, exchange. This exemption allows a property owner to purchase another property of the same type, using the proceeds (gains) from the sale of the first property without incurring additional capital gains taxes. An apartment building can be traded for an apartment building, for example, and a residential rental home can be traded for another residential rental home.

For example, let’s say an investor sells a single-family residential rental property for a $200,000 capital gain, and then purchases a new single-family residential rental property for at least $200,000. Thanks to the 1031 Like-Kind Exchange rule, they would not be required to pay capital gains taxes on that $200,000 gain from the original sale in that tax year.

The bottom line

Many investors use capital gains as a way to build wealth and grow assets over the years beyond what they earn in ordinary income from a job. Although taxes aren’t automatically withheld from this income the way they are from wages, they are still due.

Taxes on the growth of one’s investments — called gains — are generally taxed differently than ordinary income. Determining how much is owed on these gains depends on a number of factors including how long the asset was owned, how much the taxpayer earns in taxable income, and the type of asset it is.

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