What Is Capital Gains Tax

Capital gains tax is the tax Americans must pay on any profits generated from the sale of assets, including stocks, real estate and businesses.

The Internal Revenue Service generally considers these gains taxable income. The tax rates on capital gains can vary depending on the income of the taxpayer and the length of time the investor has held the asset before selling. Capital gains from assets you have held for longer than one year are considered long-term capital gains and are taxed at a lower rate than short-term gains on assets held less than a year.

A capital gain is a profit generated by selling an asset, such as a business, real estate, cars, boats, stocks or bonds. The IRS considers the sale of these types of assets a taxable event. Any taxable event must be reported to the IRS on your income tax form. An asset’s cost basis is typically the amount the owner paid for the asset when it was purchased. If the owner sells the asset for more than its cost basis, a capital gain is generated. Assets sold for less than their cost basis produce a capital loss.

Any investor buying and selling stocks, bonds or other assets owes capital gains tax on the profits from those investments. However, unlike property taxes that are paid each year the property is owned, capital gains tax is paid only when an asset is sold. Capital gains tax is determined based on several factors, including how long you’ve owned the asset, the cost of buying and owning the asset, your income tax bracket and your marital status.

If you have a brokerage account, you will likely receive a breakdown of all the asset sales you made in your account during each tax year in January of the following year via a Form 1099-B. The 1099-B form includes basic information needed to calculate your capital gains taxes, including a brief description of each asset sold, the dates it was purchased and sold, the cost basis of the transaction and how much money you received from the sale. Taxpayers then calculate and pay their capital gains tax on their income tax return via Schedule D, or Form 1040, and Form 8949, if needed.

In addition to federal capital gains tax, investors typically must also pay state capital gains tax.

The current federal capital gains tax rate structure was established under the Tax Cuts and Jobs Act of 2017. The income brackets are adjusted on an annual basis, but the rates do not change.

The current long-term capital gains tax rates for single filers are 0% for taxable incomes up to $40,400, 15% for incomes of between $40,401 and $445,850, and 20% for incomes of $445,851 or more.

Short-term capital gains are taxed using the same tax brackets and rates as ordinary income. For single filers, these rates range from 10% for taxable incomes up to $9,950 to as high as 37% for taxable incomes of more than $523,600.

State and local capital gains vary on a state-by-state basis, and the nine states that do not currently collect income tax do not collect capital gains tax either.

Capital gains on real estate investments are generally taxed at the same long-term and short-term capital gains rates outlined for other assets based on whether or not you have owned the property for at least one year.

The IRS provides a tax break for anyone selling a primary residence. Single taxpayers selling a primary residence in which they have lived for at least two years out of the five years preceding the sale are not required to pay taxes on their first $250,000 in capital gains from the sale of the property. Married taxpayers filing jointly are allowed to avoid taxes on up to $500,000 in capital gains from the sale of their primary residence.

Capital gains tax can be an unexpected expense for investors who do not keep up with their profits throughout the year. Investors looking to minimize their capital gains tax burden may also choose to delay selling stocks or other assets until they have held them for at least a year to pay the lower, long-term capital gains tax rate.

Capital gains taxes can also catch taxpayers by surprise if they have inherited property or other assets. In these instances, the cost basis of the asset is its value at the date of the previous owner’s death.

Any capital losses generated in a given tax year can be used to offset capital gains and reduce your overall tax burden. Capital losses are first used to offset capital gains of the same type, with short-term losses offsetting short-term gains and long-term losses offsetting long-term gains. The remaining net losses of either type can then be used to offset gains of the other type.

Once all capital gains have been offset for a given tax year, single filers can use up to $3,000 in remaining capital losses to offset other types of income. If there are still capital losses remaining after the $3,000 income offset, those capital losses can be carried over to offset capital gains and income in subsequent tax years.

Investors often choose to sell underperforming stocks or other assets before Dec. 31 to offset capital gains for that year, a strategy known as tax loss harvesting.

Retirement investors can reduce or eliminate their capital gains tax burden by taking advantage of tax-advantaged or tax-free retirement accounts. Accounts such as 401(k)s, 403(b)s and traditional individual retirement accounts are tax-advantaged accounts. These accounts are funded with pretax or tax-deductible contributions, capital gains in the accounts are tax-deferred, and withdrawals are taxed as ordinary income – usually after the taxpayer is retired and in a lower income tax bracket.

Federal capital gains taxes were established in the U.S. in 1913. Capital gains were initially taxed at the same rate as income taxes up to 7%, depending on income. The Revenue Act of 1921 split capital gains into short-term and long-term gains for tax purposes. Short-term gains were taxed at regular income rates, while long-term gains were taxed at 12.5%.

The maximum long-term capital gains tax rate rose to 22.5% in 1936 and climbed to an all-time high of 35% in 1972. The current 20% maximum rate on long-term capital gains has been in place since it was raised from 15% by the Patient Protection and Affordable Care Act in 2013.