Whether or not you’re a financial professional, you may have trickled into the stock market (or real estate) to try your hand at investing. And if you did see profits, depending on the holding period, you probably had to pay capital gains tax. On the other hand, if you lost money, you may have been able to report a loss and take the deduction.
Nobody likes taxes. It doesn’t seem fair, having to fork over a portion of your hard-earned income to the government.
This means that we’re all fighting a constant battle with the tax man. We try to negotiate and bargain for better deals through various strategies such as deductions and tax credits.
The same is true of capital gains and losses.
This article will cover how capital gains and losses affect your taxes. We will also include a few tips to minimize your capital gains tax.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. Tax and investing situations can be very complex and laws vary by region. It may be wise to consider the help of an industry professional when it comes to tax- and investing-related decisions.
If you don’t yet have industry professionals handling your portfolio, we can help! Check out Financial Professional’s investment marketplace, where we partner with some of the best in the business to help find the right investment for you.
What are Capital Gains?
First off, let’s talk about capital gains. This refers to a rise in the value of any capital asset that is worth more than you bought it for.
There are two types of capital gains: unrealized and realized.
Unrealized capital gains are profits on paper, whereas the actual transaction (sale) hasn’t occurred. On the other hand, realized capital gains occur when you sell the asset in question. When it comes to taxes, you only have to pay on your realized capital gains.
Furthermore, capital gains may be short-term (one year or less) or long-term investments (more than one year).
In 2020, the capital gains tax rates are 0%, 15%, and 20%. The amount that you pay depends on how long you hold the assets.
For assets held one year or less, these are slapped with the ordinary income tax bracket of 10%, 12%, 22%, 24%, 32%, 35%, or 37%.
Capital Gains and Taxes
Let’s give some examples of how capital gains can affect your taxes.
Example 1: Larry Long
Larry Long is a single investor whose only source of income comes from investment activities.
Let’s say that Larry buys $500,000 worth of Home Depot stock (stock symbol $HD) in March of 2018. He sells his stock in August of 2019 at a $150,000 profit.
Since Larry’s total income is $150,000 and he held over one year, he qualifies for the 2019 long-term capital gains tax rate of 15%. Thus, he owes the IRS $22,500 from his $HD profit.
Example 2: Sherry Short
Sherry Short is in a similar position to Larry. She is also a single investor who lives off the profits of her investments.
Sherry Short decides to hop on the bandwagon and purchase $500,000 of $HD stock in December of 2018. She then sells her investment in August of 2019 for $150,000 in profit.
Because Sherry’s total income is $150,000 but she did not hold over one year, she does not qualify for the long-term capital gains tax rate. Instead, she has to pay her ordinary income tax bracket of 24%. Thus, she owes the IRS $36,000 from her $HD profits.
These examples show how drastically just a few months can change your capital gains tax situation. Since Larry Long held over one year, he saved of $10,000 in taxes. Sherry Short, on the other hand, got slapped with a $36,000 tax bill for not waiting a few more months!
Just like your stock gains, dividends are also taxed.
There are two types of dividends to consider: qualified and non-qualified dividends.
Simply put, qualified dividends are taxed at the long-term capital gains tax rate if held accordingly.
Non-qualified dividends, as the name suggests, don’t qualify for that rate. Instead, they are taxed at the ordinary income tax bracket, even if they stock is held for more than one year.
However, most of the everyday dividend-paying stocks on the market pay qualified dividends, so most investors won’t have to worry too much about this.
Capital Losses and Taxes
When it comes to reporting losses from capital assets, you may only report up to $3,000 net loss per year. You can then use the $3,000 loss as a deduction on your taxable income.
But if you have a loss of $3,001 or more, you will have to carry the loss into the next fiscal year, as your deduction is limited to $3,000.
When the next year comes around, you can take another $3,000 deduction if you end the year with enough in capital losses.
Let’s look at an example.
Luke Losses is a single investor whose income comes from his full-time job in food service and his stock trading activities.
His total income from food service in 2018 is $50,000, while his trading account is net negative $9,000.
Although Luke lost significantly more, he is only able to deduct $3,000 of his net loss from his taxes in 2017. This gives him a taxable income of $47,000.
But, assuming that he does not gain or lose anything from his investments in the next three years, he can carry forward his losses to take a deduction of $3,000 in 2018, and again in 2019, to fully offset his losses.
The Wash Sale Rule
When it comes to investing and reporting capital gains and losses in your tax return, it’s important to keep in mind the wash sale rule. This rule was designed to try and avoid investors selling stock at a loss for the tax benefits.
A wash sale occurs when you sell a security at a loss, and then buy the same or similar security back within 30 days.
If you do this, you may not be able to take a deduction from your total taxable income. That is the wash sale rule.
Let’s give an example.
Will Washer decides to invest $50,000 in $HD at $100 per share. On July 31, $HD drops to $50 per share, making Will’s investment worth $25,000. He sells all of his stocks at a loss.
Now, let’s say that Will Washer bought 500 $HD again on August 15 at $60 per share, within 30 days of selling his old shares on July 31. His capital loss will be deferred until he sells these new shares.
Since Will Washer participated in a wash sale, his adjusted basis in the new shares is equal to the new basis plus this old loss. Thus, his basis increases by $25,000 and becomes $55,000 (500 x 60 + 25,000).
However, Will Washer’s actual basis (500 x 60) is only $30,000. By participating in a wash sale, then, he adjusted and increased his basis by the $25,000 loss that wasn’t allowed.
What about 1031 Exchanges?
A 1031 exchange is a reinvestment of real estate capital gains to avoid paying taxes on profits received from the property. To explain the concept, let’s use another example.
Ronald Reit bought $250,000 worth of real estate two years ago. He now has $375,000 invested in the property, and sells it for a $125,000 profit (a 50% Return on Investment, or ROI).
Ronald must sell all the profits he wishes to realize and invest the total amount in another real estate property within 45 days of the sale to avoid paying capital gains tax on his profit.
Tips to Minimize Capital Gains Taxes
No one likes to pay taxes – but it’s rarely possible to weasel out of your full tax bill. However, we’ve put together a few tips to help you minimize your capital gains taxes as much as possible.
1. Try to hold your investments for more than one year.
This allows you to qualify for the lower, long-term capital gains tax rate.
2. Exclude your homes sales from your tax bill.
There are two rules that come with this:
- You must own a home and use it as your main residence for two out of five years
- You must not have excluded another home from capital gains tax in the two years you lived in said house.
If you abide by these rules, you can exclude up to $250,000 of capital gains from your home sales if you’re single. Married couples can exclude up to $500,000.
3. Carry losses over.
As we discussed, you may be able to deduct losses from your total taxable income if your net capital gain is negative. Since you can only deduct a $3,000 loss for the current year, carrying over your losses can help you minimize your capital gains tax impact in future years.
Keep in mind, however, that this only applies if you continue to see net losses (or at least no gains) in future years.
4. Invest in a Roth IRA.
Roth IRAs are retirement accounts that grow over time. The best part is, you don’t have to pay capital gains taxes on your profits when you withdraw!
A Final Word on Capital Gains and Losses
There are many different types of taxes to be aware of come spring. If you’re an investment, trader, or asset collector, capital gains is an important tax to keep in mind!
To learn more about investment income taxes, check out our article on portfolio taxation.
Questions on capital gains and losses, or how they relate to taxes? Let us know!