UPDATED 01/12/2024
In addition to state and federal taxes on income, there may also be taxes on the increase in value when individually owned property, aka a capital asset is sold. This is commonly referred to as a capital gains tax. While it is taxable annually as incurred, the mechanics of calculating capital gains taxes are different than other forms of taxation.
The single most important thing to understand when it comes to capital gains is to consider taking advantage of the lower tax rates on long-term capital gains.
Long-term capital gains rates generally apply when a capital asset is held for more than one year before being sold. Capital assets held for less than one year are subject to short-term capital gains which are taxed at what are called ordinary income tax rates.
Ordinary income tax rates are determined by where you land in the income tax tables for a given year.
Typically, when planning for capital gains, the goal is to have long-term capital gains treatment because the tax rates are typically lower than ordinary income tax rates. Please note that your particular state may also have its own capital gains tax. Speak to your tax professional to see if this may apply to you.
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Capital Assets
Capital gains and losses are generated when a taxpayer sells a capital asset.
The IRS defines a capital asset through exclusion: all property owned by a taxpayer is considered a capital asset, except for specific exclusions like inventory, accounts receivable, supplies used in business, and intangible creations like a copyright or musical score.
This means that possessions like a home, real property, furnishings, businesses, client lists, collectibles, art, and investments may all be considered capital assets.
If you exchange or sell an asset for more than your basis, you will have either a long-term or short-term capital gain. Basis is the purchase price or cost of the asset plus any commissions, fees, sales taxes paid, and/or improvements (not repairs) to real property made.
You can also have a capital loss which occurs when you sell a capital asset for less than your basis. Gains and losses are generally not taxable until that gain or loss is realized by actually selling the asset.
Calculating a Capital Gain or Loss
There are three basics steps to calculating an individual taxpayer’s taxable capital gain or loss. The process is called “netting” the capital gains in groups. The groups are based, not on the type of capital asset owned (collectibles, stocks, bonds, etc.), but on the holding period for the items.
Please note that determining the amount of capital gain is different than determining the actual amount of taxes owed on that gain – this calculation comes later. Steps 1 and 2 in the “netting” process below can be calculated in reverse order.
Step 1: Net all long-term capital gains and losses.
In this case, the taxpayer has a long-term capital loss (LTCL) of $150.
| Long-Term Assets Sold | Cost Basis
(What you paid for the asset) |
Sales Price | Gain / Loss |
| ABC Stock | $1,000 | $1,500 | $500 |
| XYZ Stock | $2,000 | $1,000 | -$1,000 |
| TUV Stock | $500 | $800 | $300 |
| LMN Stock | $1,000 | $800 | -$200 |
| DEF Stock | $1,200 | $1,500 | $300 |
| GHI Stock | $1,150 | $1,100 | -$50 |
| Net Long-Term Capital Loss | -$150 |
Step 2: Net all short-term capital gains and losses.
In this case, the taxpayer has a short-term capital gain (STCG) of $50.
| Short-Term Assets Sold | Cost Basis
(What you paid for the asset) |
Sales Price | Gain / Loss |
| GHI Stock | $750 | $800 | $50 |
| JKL Stock | $1,000 | $1,100 | $100 |
| MNO Stock | $1,000 | $1,500 | $500 |
| PQR Stock | $2,200 | $2,000 | -$200 |
| Short-Term Capital Loss Carry Forward* | $2,200 | $1,800 | -$400 |
| Net Short-Term Capital Gain | $50 |
*Example of short-term loss carried forward from previous tax year
Step 3: Net these two short-term and long-term numbers together.
| Type | Gain / Loss |
| Short-Term Capital Gain | $50 |
| Long-Term Capital Loss | -$150 |
| Net Long-Term Capital Loss | -$100 |
- After all is said and done, the taxpayer has a net long-term capital loss (LTCL) of $100.
Possible Capital Gain or Loss Scenarios
| Resulting Capital Gain or Loss | Cause |
| Both a STCG and LTCG | Both short-term and long-term capital gains exceed short-term and long-term capital losses |
| LTCL | LTCL > STCG |
| STCL | STCL > LTCG |
| LTCG | LTCG > STCL |
| STCG | STCG > LTCL |
| Both STCL and LTCL | Both short-term and long-term capital losses exceed short-term and long-term capital gains |
Tax Treatment
Once the netting process is complete, the tax treatment can be determined.
A short-term capital gain will be added to the amount taxed as ordinary income. Ordinary income is taxed at the rates provided on the federal income tax tables (see below) as is income from a job, pension, etc.- this is not preferred. You’ll want to try and avoid any short-term capital gains for the most part, however it can still make sense to realize them in certain situations.
A long-term capital gain, referred to as net capital gains, are not included in the ordinary income tax calculation, and will be taxed at preferred capital gains tax rates. Capital gains tax rates have their own table (similar to the federal ordinary income tax table) and differ depending on how you file your taxes – married filing joint or separate, surviving spouse, single, head-of-household, etc.
A net capital loss, whether short-term or long-term, can be used to offset up to $3,000 in ordinary income in the year realized. Any additional losses over $3,000 can be “carried forward” into future years.
Sometimes individual taxpayer losses will exceed all capital gains in a given year, as well as the $3,000 ordinary income offset. This loss, whether it is short-term or long-term, can be used to offset gains and up to $3,000 in ordinary income in future years! This process can continue until the capital losses are depleted. More on that later.
2024 Capital Gains Tax Rates
The preferred long-term capital gain tax rates for most types of capital assets are 0%, 15%, or 20% depending on your taxable income on your tax return. This is not the same as your gross income.
Assets that are considered “collectibles” by the IRS such as art, baseball cards, fine wines, rare coins, etc. are taxed at a 28% capital gains rate if held for more than a year (long-term).
Not surprising, there is actually another type of tax that may be owed in addition to the capital gains rate, which is referred to as the Net Investment Income Tax (NIIT) or “Medicare Surtax” of 3.8%.
- The Net Investment Income Tax applies to those who have a Modified Adjusted Gross Income aka MAGI of $200,000 (single filer) or $250,000 (filing married filing joint).
- If applicable, you pay the Net Investment Income Tax on the lesser of your net investment income, or the amount of your modified adjusted gross income aka MAGI over and above the thresholds mentioned based on your filing status.
Here are the 2024 capital gain tax brackets that apply to long-term capital gains for Married Filing Joint (MFJ), Single Filers, and Estates and Trusts:
|
Federal Long-Term Capital Gains & Qualified Dividend Tax Rates 2024 (Based on taxable income noted below) |
|||
|
Married Filing Joint |
Single |
Estates Trusts |
Long-Term Capital Gains Rate |
| Up to $94,050 | Up to $47,025 | Up to $3,150 | 0% |
| $94,051 to $583,750 | $47,026 to $518,900 | $3,151 to $15,450 | 15% |
| Over $583,750 | Over $518,900 | Over $15,450 | 20% |
Here are the 2024 federal income tax brackets that apply to ordinary income and short-term capital gains for Married Filing Joint (MFJ), Single Filers:
|
Federal Income Tax Rates for Ordinary Income & Short-Term Capital Gains 2024 (Based on taxable income noted below) |
|||
|
Married Filing Joint |
Single |
Estates Trusts |
Federal Income Tax Rate |
| $0 to $23,200 | $0 to $11,600 | $0 to $3,100 | 10% |
|
$23,201 to $94,300 |
$11,601 to $47,150 |
– |
12% |
|
$94,301 to $201,050 |
$47,151 to $100,525 |
– |
22% |
| $201,051 to $383,900 | $100,526 to $191,950 | $3,101 to $11,150 | 24% |
|
$383,901 to $487,450 |
$191,951 to $243,725 |
– |
32% |
| $487,451 to $731,200 | $243,726 to $609,350 | $11,151 to $15,200 | 35% |
| $731,200 or more | $609,350 or more | Over $15,200 | 37% |
Calculating Capital Gains Taxes Owed
Calculating the actual capital gains taxes owed is the final step of the process and it has a very important caveat. That is that capital gains stack on top of ordinary income.
The preferred tax rates on long-term capital gains are “bracketed” and they apply in a similar way to ordinary income tax brackets.
The capital gains taxes start in the bracket where ordinary income ends. This is referred to as “stacking.”
Here’s an example to see how the “stacking” concept and marginal brackets work:
Tom and Rita have taxable ordinary income, not including any capital gains, of $150,000.
They also have a net long-term capital gain of $500,000, generated by a large investment portfolio reallocation and sale of real estate with a partial taxable long-term capital gain.
The capital gains stack on top of the ordinary income of $150,000. The $150,000 in taxable income has them in the 22% ordinary income tax bracket.
However, for purposes of calculating their long-term capital gains taxes, we need to add their gains on top of their other ordinary income ($150,000).
Once we stack the capital gain on top of their income, a 15% capital gains tax rate will apply to the first $100,000 in capital gains. This is because their taxable income of $150,000 already puts them in the 2nd capital gains “tier”.
The $100,000 is the difference between the start of the Net Investment Income Tax threshold of $250,000 (tricky I know) and the $150,000 in ordinary income which was our starting point.
The next ~$333,750 in gain is subject to the 15% capital gain rate + 3.8% NIIT (18.8%).
This leaves them with ~$66,250 subject to the 20% capital gain rate + the 3.8% NIIT (23.8%).
Note that even at the highest capital gains rate and additional surtax, the tax rate is still lower than the ordinary income rate they would have been subject to otherwise.
Capital Loss Carryforward
The IRS allows an individual or married taxpayer’s capital losses to be carried over for use in future years until the loss is “used up”.
When a capital loss that is carried over to a future tax year, it retains its original long-term or short-term character.
- A short-term capital loss carryforward offsets short-term capital gains incurred in the “carryover year” first.
- If a net short-term capital loss results due to the carryforward loss being larger than the “carryover year’s” short-term capital gain, the carryforward loss next offsets net long-term capital gain incurred in the “carryover year”.
- Lastly, any additional carryforward losses offset ordinary income, up to a maximum amount of $3,000. This means that you can potentially use up to $3,000 in a given year to offset income from other sources like pension income, income from employment, etc.
- If you happen to have any additional short-term losses to carryforward, those would be carried to the next tax year and the same order and rules would apply.
- If instead you have a long-term capital loss carryforward, this first reduces net long-term capital gain in the “carryover year”, followed by net short-term capital gain, and lastly ordinary income, again up to the $3,000 maximum.
Capital Gain Exclusion on Sale of Primary Residence
If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse. This is known as the Section 121 Exclusion.
In general, to qualify you must meet both the ownership test and the use test. You’re eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. The two years do not need to be consecutive.
Installment sales can still qualify for the exclusion even though they are typically used when capital gains taxed would be owed, and the exclusion not met. An installment sale may also be used in this situation if you have a gain above-and-beyond your exclusion amount and want to spread that gain over a number of years.
Another way to think about it is if you lived in your home for a period of several years and then move, you have up to 3 years to sell the home for the exclusion. Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.2
Strategies to Reduce Capital Gains Taxed Owed
Here are a few tips that may help you reduce or potentially eliminate capital gains:
- Sell capital assets in years when your income will be lower than others. This will put you in the lower ordinary income tax brackets, and therefore can also put you in the lower 0% capital gains bracket. For 2021, you can make up to $80,800 in income (married filing joint) and remain in the 0% capital gains bracket!
- Hold on to your capital assets for at least a year (over 12 months) to avoid short-term capital gains if possible.
- Use tax advantaged investment vehicles when warranted like IRAs, Roth IRAs, 401(k)s, 457(b), 403(b), 529 Plans, some non-qualified annuities, etc.
- Take advantage of the Section 121 Exclusion on your personal residence!
- Consider using an installment sale when selling a piece of property or a business. This will allow you to distribute the gain over a number of years.
- Some capital assets make sense to actually die with! When someone passes away, the beneficiary(ies) of the capital asset get a “step-up” in cost basis to the fair value on the date of death (appraised value for real property). In cases where an asset is appreciating quickly, an Alternate Valuation Date can be used that instead uses the valuation date 6-months after the date of death. For the beneficiary, his can help eliminate/mitigate capital gains on the asset if sold, that would have been realized had the original owner sold or gifted the asset before death.
- If you have multiple “buckets” of assets you draw income from (brokerage account vs. IRA vs. Roth IRA vs. investment property), you may be able to adjust which ones you take from when planning to sell a capital asset or re-balance an investment account that will be subject to large capital gains.
- Tax gain and loss harvest in your brokerage accounts when possible! (try to avoid wash-sales when loss harvesting). This takes careful analysis and may make sense to use a professional. Check out our podcast episode on tax gain and loss harvesting here.
- Group together any charitable contributions in order to offset gains that may be produced in a given year (must “itemize” on your tax return).
- Keep track and carry forward your capital losses. Having capital losses provides you with flexibility when needing to make decisions that will involve generating a capital gain in future years.
- Re-balance your taxable brokerage accounts with dividends rather than have the dividends reinvest back into the same investment. Why? This will allow you to purchase more of the under-performers without having to sell shares of the winners and cause capital gains!
- Be mindful of particular investments in your taxable brokerage accounts that produce consistently high Capital Gain Distributions. Check your 1099 tax form from the custodian your account is with to see if these apply to you. If so, there are likely some alternative yet similar investments you can use that produce low-to-no capital gain distributions.
- Consider using a Charitable Remainder Trust (CRT) on highly appreciated assets.
The Bottom Line
Understanding taxes is difficult. While taxes are one of the only things certain in life, we should do all we can to mitigate how much we pay within the law. Don’t leave the IRS a tip!
As goes the famous quote from judge Learned Hand:
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
We all have the opportunities to pay less, but it is ultimately our own responsibility to understand how to do so. If you aren’t confident navigating tax planning waters on your own, don’t hesitate to reach out to a team of qualified professionals.
Free PDF Download: 2024 – Important Numbers to Know
For more creative planning and investment insights, check out our podcast: Retired·ish.
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ and Enrolled Agent located in Riverside and Orange County, CA.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
1 https://www.taxpolicycenter.org/briefing-book/how-are-capital-gains-taxed
2 https://www.irs.gov/taxtopics/tc701
Refer to Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific tax issues with a qualified tax or legal advisor.