Simply put, the term capital gains refers to the profit made off of selling an asset. This type of profit is earned when an asset’s sale price is higher than its purchase price. While this term is commonly used to discuss stock sales, it can also refer to the earnings made from selling other types of assets, such as real estate or art.
As is the case with other types of income, capital gains affect how you file and pay taxes. To learn more about different types of capital gains and their taxes, keep reading.
Capital gains basics
How do you calculate capital gains? Imagine an investor wants to sell his shares in Apple stock. If the investor initially purchased 100 shares of Apple stock at $100, he initially invested $10,000. If he later sells those shares at $200 each ($20,000), he has made a profit of $10,000. In other words, the investor’s gains were $10,000 in this transaction.
Short-term capital gains
Short-term capital gains are profits on an asset that has been held for one year or less. These gains can be factored into your income like any normally earned wage. For example, imagine that you purchased a property in February 2019 for $100,000 and sold it in January 2020 for $120,000. When you file taxes that year, you would add the $20,000 of capital gains from that transaction to your base salary or wages.
In the previous example, when you take these gains into account in 2020, you may be bumped into a higher income tax bracket. In such a case, it may be beneficial to your bottom line to save part of the $20,000 you made in the sale in order to pay your 2020 fiscal year taxes. While there are some ways to avoid tax on home sales, it’s usually not possible to avoid paying taxes on a home sale if it is categorized as a short-term capital gain.
Long-term capital gains
Long-term gains are taxed at a lower rate than short-term gains; sometimes, you can even avoid paying tax on long-term gains altogether. Depending on the profit you make from the sale of your asset and your filing status, your gains are taxed at different rates. Rates can be as low as 0% or as high as 20% on these types of gains. For that reason, it may be beneficial to delay the sale of an asset until you’ve owned it for more than a year.
It’s also important to note that there are exceptions to this rule. For example, art is taxed at 28% as long as it has been owned for more than a year.
Avoiding capital gains tax on the sale of your home
For many folks, their home is their largest asset. Depending on the trends in your local housing market, there’s a chance that you’ve made money off your home just by living in it!
After selling your home, there are two methods to avoid paying unnecessary tax on your capital gains. The first way is to live in your home for more than two years. If you used the property as your primary residence for two years or more (and they don’t have to be consecutive years) you are eligible for a tax break of up to $500,000 of the gains if you’re filing jointly, and of up to $250,000 if you’re filing as a single individual.
Read also: 10 tax deductions and credits you should know about
The second way is to keep track of all your home improvements. Keep the receipts from any work done on the house, from maintenance to larger home improvements. These will count towards your purchase price when calculating the total gains upon sale.
The bottom line
Although you can often pay a lower tax rate on long-term capital gains than short-term capital gains, keep in mind that tax law can be tricky. For example, veterans/service members and disabled folks may not have to pay some of these taxes.
To see if these or another one of the long list of capital gains tax exemptions apply to you, we recommend to consult your trusted tax professional. For more investment and personal finance tips, check out the rest of the Academy education library.