A capital gain occurs when you sell something for more than you spent to acquire it. This happens a lot with investments, but it also applies to personal property, such as a car. Every taxpayer should understand these basic facts about capital gains taxes.
Capital gains aren't just for rich people
Anyone who sells a capital asset should know that capital gains tax may apply. And as the Internal Revenue Service points out, just about everything you own qualifies as a capital asset. That's the case whether you bought it as an investment, such as stocks or property, or something for personal use, such as a car or a big-screen TV.
If you sell something for more than your "cost basis" of the item, then the difference is a capital gain, and you’ll need to report that gain on your taxes. Your cost basis is usually what you paid for the item. It includes not only the price of the item, but any other costs you had to pay to acquire it, including:
- Sales taxes, excise taxes and other taxes and fees
- Shipping and handling costs
- Installation and setup charges
In addition, money spent on improvements that increase the value of the asset—such as a new addition to a building—can be added to your cost basis. Depreciation of an asset can reduce your cost basis.
In most cases, your home has an exemption
The single biggest asset many people have is their home, and depending on the real estate market, a homeowner might realize a huge capital gain on a sale. The good news is that the tax code allows you to exclude some or all of such a gain from capital gains tax, as long as you meet all three conditions:
- You owned the home for a total of at least two years.
- You used the home as your primary residence for a total of at least two years in last five-years before the sale.
- You haven't excluded the gain from another home sale in the two-year period before the sale.
If you meet these conditions, you can exclude up to $250,000 of your gain if you're filing as single, head of household, or married filing separately and $500,000 if you're married filing jointly.
Length of ownership matters
If you sell an asset after owning it for more than a year, any gain you have is typically a "long-term" capital gain. If you sell an asset you've owned for a year or less, though, it's typically a "short-term" capital gain. How your gain is taxed depends on how long you owned the asset before selling.
- The tax bite from short-term gains is significantly larger than that from long-term gains - as much as 10-20% higher.
- This difference in tax treatment is one of the advantages a "buy-and-hold" investment strategy has over a strategy that involves frequent buying and selling, as in day trading.
- People in the lowest tax brackets usually don't have to pay any tax on long-term capital gains. The difference between short and long term, then, can literally be the difference between taxes and no taxes.
Capital losses can offset capital gains
As anyone with much investment experience can tell you, things don't always go up in value. They go down, too. If you sell an investment asset for less than its cost basis, you have a capital loss. Capital losses from investments—but not from the sale of personal property—can typically be used to offset capital gains. For example:
- If you have $50,000 in long-term gains from the sale of one stock, but $20,000 in long-term losses from the sale of another, then you may only be taxed on $30,000 worth of long-term capital gains.
- $50,000 - $20,000 = $30,000 long-term capital gains
If capital losses exceed capital gains, you may be able to use the loss to offset up to $3,000 of other income. If you have more than $3,000 in capital losses, this excess amount can be carried forward to future years to similarly offset capital gains or other income in those years.
Business income isn't a capital gain
If you operate a business that buys and sells items, your gains from such sales will be considered—and taxed as—business income rather than capital gains.
For example, many people buy items at antique stores and garage sales and then resell them in online auctions. Do this in a businesslike manner and with the intention of making a profit, and the IRS will view it as a business.
- The money you pay out for items is a business expense.
- The money you receive is business revenue.
- The difference between them is business income, subject to self-employment taxes.
Let a local tax expert matched to your unique situation get your taxes done 100% right with TurboTax Live Full Service. Your expert will uncover industry-specific deductions for more tax breaks and file your taxes for you. Backed by our Full Service Guarantee.
You can also file taxes on your own with TurboTax Premium. We’ll search over 500 deductions and credits so you don’t miss a thing.
As a seasoned financial expert well-versed in taxation and investment strategies, it's crucial to delve into the comprehensive understanding of capital gains and their implications, as outlined in the provided article. The article covers various concepts related to capital gains taxes, and I'll break down each key point:
-
Definition of Capital Gain:
- A capital gain occurs when an individual sells an asset for a price higher than the initial acquisition cost.
-
Scope of Capital Gains:
- Contrary to common misconceptions, capital gains are not exclusive to wealthy individuals. The Internal Revenue Service (IRS) emphasizes that nearly everything a person owns qualifies as a capital asset, including both investments (e.g., stocks or property) and personal property (e.g., cars or electronics).
-
Determining Capital Gain:
- Capital gain is the difference between the selling price of an item and its "cost basis," which typically includes the initial purchase price along with additional costs such as sales taxes, excise taxes, fees, shipping, handling, installation charges, and money spent on improvements.
-
Homeownership Exemption:
- The tax code provides an exemption for the capital gains realized from the sale of a primary residence. To qualify for this exemption, homeowners must meet specific conditions, including a minimum ownership and residency period.
-
Length of Ownership Impact:
- The duration of ownership affects the classification of capital gains. If an asset is held for more than a year before being sold, it is considered a "long-term" capital gain. Short-term gains, from assets held for a year or less, are subject to higher tax rates.
-
Tax Treatment Based on Holding Period:
- Long-term capital gains generally receive more favorable tax treatment than short-term gains, with lower tax rates. This encourages a "buy-and-hold" investment strategy over frequent buying and selling, such as day trading.
-
Capital Losses Offsetting Gains:
- Capital losses from investments can offset capital gains, reducing the taxable amount. If capital losses exceed gains, individuals may use the excess to offset up to $3,000 of other income. Any remaining losses can be carried forward to future years.
-
Business Income vs. Capital Gain:
- Gains from buying and selling items in a business context are treated as business income, subject to self-employment taxes. This distinction is essential for individuals engaged in activities like buying and reselling items for profit, as opposed to personal transactions.
In summary, a thorough understanding of capital gains, including their calculation, exemptions, and tax implications, is essential for every taxpayer, irrespective of their wealth or investment portfolio. Additionally, strategic considerations, such as the length of ownership and the distinction between business income and capital gains, play a vital role in optimizing tax outcomes.
