Capital Gains Tax: Definition and How to Calculate It

Capital Gains Tax: Definition and How to Calculate It
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Point Editorial

Filing and paying taxes is already a complicated enough process without having to worry about additional rates. That said, depending on your current and inherited possessions and your financial ventures, these fees and capital gains taxes, specifically can become a reality. 

Capital gains taxes are the fees imposed on profits made from an investment after that investment is sold, such as stocks or shares in a company, real estate, or bonds. Assets acquired from day trading are especially vulnerable to these types of taxes. 

Investment profits are only subjected to capital gains taxes once they’ve been sold or “realized” versus when they are “unrealized,” or haven’t been sold. 

Capital gains tax rates are dependent on the nature of the asset itself and an individual’s tax bracket. Generally, rates can either be zero percent, 15 percent, or 20 percent, though there are exceptions to this rule. 

The eight states that do not impose a capital gains tax are Alaska, Florida, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Capital gains are a hotly debated issue for many Americans. On the one hand, some believe it is unfair to tax these profits because it creates less incentive to invest, which harms the economy in the long run. Others argue that those earning extra income on capital wealth shouldn’t be favored by such a policy, compared to the majority of citizens whose profits only come from a regular working wage. 

Read on for more information on the capital gains tax, calculating it, and the difference between the various types of capital gains taxes. 

Short-term capital gains vs. long-term capital gains 

Generally, capital gains are the fees placed on the money earned from selling a particular asset. You can divide assets into two separate categories: short-term capital gains and long-term capital gains. 

Short-term capital gains 

Profits kept in your possession for less than a year are considered “short-term capital gains” and are taxed in the same way as regular income. The holding period for this type of asset begins the moment you acquire it up until the day you sell it. The most common example of short-term capital gains is the monthly wage you earn from working. 

The short-term capital gains tax can range anywhere between 10 and 37 percent. That all depends on your tax bracket. 

Long-term capital gains

If you’ve held onto an asset for more than a year, that profit is considered a “long-term capital gain,” in which case the accompanying capital gains tax does apply. One example is selling your home. 

The tax rate for long-term capital gains can be anywhere between zero and 20 percent. The average rate is approximately 15 percent. 

It may look like cashing in your investments more frequently will lead to quicker, more significant profits, but that isn’t always the case. Long-term investments are more practical because markets are constantly changing and are susceptible to both old and new trends. It is also important to remember that regular income tax and short-term capital gains taxes are typically higher than long-term capital gains taxes, hence why experts constantly debate and re-evaluate the topic.

How are capital gains taxes calculated?

Factors affecting how much you have to pay in capital gains include your marital status, your regular income – and, by extension, your tax bracket – and how long you've held onto your profits.

The steps to calculating your capital gains are as follows: 

Step 1: Find your basis. It's usually how much you initially paid for the asset. Be sure to include any retail fees.  

Step 2: Determine how much your "realized" amount is or, in other words, the monetary value of the asset that you sold. 

Step 3: Subtract your basis from your "realized" amount. If you sold your asset for more than you paid, you have a capital gain. If you sold it for less than you paid, you have a capital loss. 

Remember, you can deduct capital losses from your capital gains taxes. If your overall capital losses exceed more than $3,000 during the current taxing period, you can carry them over to the next period. More serious losses roll over until you're able to resolve them. So, keeping a detailed record of your losses can be beneficial.

There are online platforms available to help you calculate your numbers. Capital gains and losses are all reported on Form 8949 as part of your tax filing paperwork. You can find an estimation tool here

Capital gains tax rates 

As determined by the Internal Revenue Service, short-term capital gains are taxed identically to your regular income. Rates are one of the following percentages: 10, 12, 22, 24, 32, 35, or 37 percent. It all depends on your tax bracket. There is no zero percent rate for short-term gains. 

It is slightly different for long-term capital gains, as tax rates can be zero, 15, or 20 percent, per your filing status.

Your Filing Status 0 percent 15 percent 20 percent
Single up to $40,400 $40,401 - $445,850 over $445,850
Married, filing together up to $80,800
$80,801 – $501,600
over $501,600
Married, filing separately up to $40,400
$40,401 – $250,800 over $250,800
Head of household up to $54,100
$54,101 – $473,750
over $473,750

Exceptions to capital gains tax rates

Exceptions to the general capital gains tax rates also exist. Read on as we describe them in further detail.

Collectibles 

This category includes artwork, jewelry, precious gemstones, antiques, coins, stamps, and wine collections. These assets are taxed at 28 percent regardless of your income. 

Owner-occupied real estate  

The term "owner-occupied real estate" refers to your current or primary home, particularly when you're looking to sell it. The profits made from selling, up to $250,000, are exempted from capital gains taxes, but the rest is not. However, you must have lived at the property for at least two years before putting it up for sale.

Investment real estate

Investors may be entitled to some tax reductions. Because of the ever-dynamic nature of the real estate market, the value of a home tends to depreciate or decrease in value over time. Property investors are allowed a bit of a cushion to make up for losses.

Nevertheless, you are still subject to a 25 percent tax rate on the depreciated value of selling a home since you cannot receive a second tax break on the same asset simply because of economic fluidity.  

6 ways to minimize capital gains taxes

Regardless of how it may sound, learning about and implementing tactics to minimize your capital gains tax is entirely legal. Listed below are five common strategies.

Tip 1: Hold onto your investments for a year or more. That way, once your assets are taxed later, they will be taxed for less. 

Tip 2: Consider a Roth 401k retirement plan. If you pay into this specific type of plan – to which you can contribute up to a maximum of $19,500 per year – you won’t owe any capital gains taxes once you’ve retired and collected your accumulated payments. However, for the money to be tax-free upon withdrawal, you must have had the Roth 401k account for longer than five years, and you must be at least 59 years old. 

It is important to note that this is not the case with a traditional 401k plan. 

Tip 3: Remember, up to $3,000 can be reduced from your taxes should you experience investment losses. Selling a less profitable stock, for instance, can be a small blessing in disguise. 

Tip 4: Use a robo-advisor. Robo-advisors are software-based financial assistants that can manage your investments for you based on mathematical formulas as economic trends. 

Wealthfront, Vanguard Digit Advisor, Betterment, and Ellevest are just a few examples of robo-advisors. 

Tip 5: Rebalance with dividends. Dividends are additional profits that a company distributes to its shareholders. Usually, this occurs when the company has brought in a surplus of profit. Rebalancing dividends thus means reinvesting that bonus into your assets that are underachieving. 

Tip 6: Talk to an expert. Tax policies are complicated and frequently change due in part to government evaluation. Speaking with a specialist in such a field can be a huge stress reliever and an eye-opening experience.

Point’s contributions

Buying, selling, and managing your investments and their subsequent profits, and navigating the capital gains tax rates that accompany them, are good skills to have in this day and age. But it isn't the only way to make your money work harder for you. 

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Point works hard to put your mind at ease, making it an excellent tool to launch yourself into the ever-expanding world of finances without having to worry about what your money's up to.

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