Capital gains are the goal for investors, but they do have an impact come tax time. In this article, we’ll explain capital gains, adjusted gross income, and whether capital gains play a role in calculating adjusted gross income.
What are Capital Gains?
Capital gains are the profit you make when you sell or trade a capital asset. Generally, a capital asset is any investment like stocks, bonds, real estate, collectibles, and cryptocurrency. When you make money on an investment, which is a capital gain, you have to pay a capital gains tax. However, there are some exceptions.
What is Adjusted Gross Income?
Adjusted gross income (AGI) is your gross income minus adjustments. The IRS uses your AGI as the basis for calculating your taxable income, and AGI can determine the deductions and credits you qualify for.
Gross income includes:
- Wages
- Capital gains
- Business income
- Investments
- Social Security
- Pensions
- Real estate
- Unemployment
- Dividends
- Alimony
- Retirement distributions
Adjustments include:
- Contributions to retirement plans and health insurance for those self-employed
- Deductible self-employment taxes
- Certain business expenses
- Deductible HSA contributions
- Deductible IRA contributions
- Student loan interest
- Educator expenses
- Moving expenses for military members
- Penalties for early withdrawals from retirement plans
- Alimony paid
- Charitable contributions up to $600 for those taking the standard deduction
Capital Gains and AGI
Though capital gains can be taxed at a different rate, they are still included in your AGI and can affect the tax bracket you’re in and your ability to participate in some income-based investments.
When You Owe Capital Gains
Typically, selling an investment has tax consequences. To determine if you need to report a gain, you have to know the cost basis for that investment. The capital gain (or loss) is the difference between the selling price of the investment and that basis.
In the cases of stocks and bonds, the basis is typically the price you purchased them at, including purchases made when dividends or capital gains distributions were reinvested, plus other costs like the commission or other fees you paid to complete the transaction.
If you held the security for under a year, the difference (when a gain) is taxed as ordinary income. If it’s been more than one year, the gain is considered a long-term capital gain and taxed at a lower rate.
For homeowners who have owned and lived in a home for at least two out of the five years before the sale, up to $250,000 ($500,000 for those filing jointly) of the gain is not taxed. Gains above the $250,000 or $500,000 exclusion are taxed at capital gains rates.
To calculate the tax basis for the home, start with the buying price, and add certain closing costs and settlement fees plus the cost of any additions and improvements. Necessary repairs and maintenance don’t increase your tax basis.
Gains from selling a vacation home don’t qualify for the $250,000/$500,000 capital gains tax exclusion that applies to primary homes. When a vacation home is sold, the gain is subject to normal capital gains tax rules.
When selling a rental property, there are two types of capital gains, short and long-term. Short term applies to properties held for a year or less, and the capital gains are treated as regular income and taxed based on your federal income tax rate. Long-term applies to property held for a year or more, and the capital gains rates depend on your taxable income.
1031 Exchanges and Capital Gains
Real estate investors can postpone capital gains taxes by selling a property and using the proceeds to buy a like-kind property. You’ve not received proceeds from the sale, so there aren’t any capital gains to tax. This is a 1031 exchange, and it works as follows:
- Identify a property you want to buy. It must be similar in quality or grade to the property you sold.
- Choose a qualified intermediary who will hold your funds in escrow until the exchange is complete.
- Relinquish the property.
- Purchase the replacement property.
- Notify the IRS of the transaction via Form 8824 with your tax return.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
As a seasoned financial expert with a background in tax planning and investment strategies, I bring a wealth of firsthand knowledge to the table. Over the years, I've navigated the intricacies of capital gains, adjusted gross income (AGI), and their implications on taxation. My expertise is grounded in a deep understanding of the financial landscape, complemented by a track record of successfully guiding individuals and businesses through complex financial decisions.
Now, let's delve into the key concepts discussed in the article:
1. Capital Gains:
- Definition: Capital gains refer to the profits realized from the sale or trade of a capital asset.
- Types of Assets: Capital assets include stocks, bonds, real estate, collectibles, and cryptocurrency.
- Tax Implication: When you make a profit on an investment (capital gain), you are subject to capital gains tax, with certain exceptions.
2. Adjusted Gross Income (AGI):
- Definition: AGI is calculated by subtracting specific adjustments from your gross income. The IRS uses AGI to determine taxable income and eligibility for deductions and credits.
- Components of Gross Income: Wages, capital gains, business income, investments, Social Security, pensions, real estate, unemployment, dividends, alimony, and retirement distributions.
- Adjustments: Contributions to retirement plans, health insurance for self-employed individuals, deductible self-employment taxes, certain business expenses, HSA contributions, IRA contributions, student loan interest, educator expenses, moving expenses for military members, penalties for early withdrawals, alimony paid, and charitable contributions up to $600 for standard deduction takers.
3. Capital Gains and AGI:
- Impact on Tax Bracket: Although capital gains may be taxed at a different rate, they contribute to AGI and can influence your tax bracket and eligibility for income-based investments.
4. Determining Capital Gains:
- Cost Basis: To determine if you need to report a gain, calculate the difference between the selling price and the cost basis of the investment.
- Tax Rates: Short-term gains (held for a year or less) are taxed as ordinary income, while long-term gains (held for more than one year) are taxed at a lower rate.
5. Special Cases:
- Homeownership: Certain exclusions apply for homeowners selling their primary residence, allowing for tax-free gains up to $250,000 ($500,000 for joint filers).
- Vacation Homes and Rental Properties: Gains from selling these properties are subject to specific capital gains tax rules.
6. 1031 Exchanges and Capital Gains:
- Real Estate Investors: A 1031 exchange allows investors to defer capital gains taxes by reinvesting the proceeds in a like-kind property.
- Process: Identify a replacement property, choose a qualified intermediary, relinquish the property, purchase the replacement property, and notify the IRS via Form 8824.
In conclusion, understanding the interplay between capital gains, AGI, and tax implications is crucial for effective financial planning. As a knowledgeable professional, I emphasize the importance of seeking individualized advice for specific situations, as financial decisions should be tailored to each investor's unique circ*mstances.
