There’s nothing like making a good investment. It can feel like you’ve made a ton of money doing literally nothing. But wait, what is this, Uncle Same wants their share of your winnings? You did all the work; why should the government get anything from it?
When you sell one of your investments for a profit, you owe what is known as a capital gains tax. Can we learn how to avoid capital gains taxes? Unfortunately, there’s no way to avoid paying these taxes in full, that’s called tax fraud and is a big no-no, but there are ways to reduce the amount you owe.
What is a capital gains tax?
As mentioned above, when you sell your investments for a profit, you owe tax on those profits. These taxes are the so-called capital gains tax. Think of it the same way you’re taxed on your regular income, only you didn’t have to work as hard to earn the money you’re taxed on.
Profits are taxed as soon as they become realized capital gains rather than unrealized capital gains. When investors talk about unrealized gains, they’re talking about their investments that have appreciated but haven’t sold yet. Unrealized gains only exist on paper. Once you sell an investment, your gains may be considered realized gains, and you will be taxed on them at that point.
Which assets are eligible for capital gains tax?
Capital gains tax applies to what is known as capital goods. Before you can learn how to avoid capital gains taxes, you need to know which assets they apply to. Examples of capital goods include, but are not limited to:
StocksBondsJewelleryYour homeHome furnishingsYour vehicleGold and silverNew collections (coins\stamps etc.)
However, not every capital you sell is subject to capital gains tax. Examples of assets without capital are:
Business inventory Debtors acquired in the normal course of business Business property to be depreciatedReal estate that is used as a rental object in your profession or business
Also excluded from capital gains treatment are certain self-created intangible assets, such as:
CopyrightsLiterary, musical or artistic compositionsLetters, memoranda or similar propertyA patent, invention, model, design (patented or not) or secret formula
Short vs. Long Term Capital Gains
As with ordinary income tax brackets, there are different amounts you can tax on your capital gains. It usually depends on how long you held the investment when determining the tax amount.
Short-term capital gains are gains on investments that you hold for less than a year. The tax brackets for short-term capital gains are similar to those for ordinary income. However, the short-term capital gains tax also takes into account your application status (single, married, etc.). As a result, the tax rate on short-term gains is a maximum of 37%.
Long-term capital gains tax is paid on investments that you have held for a year or more. The long-term capital gains brackets are a bit simpler. If you earned less than 41k for a single filer or 83k for a married couple in 2022, you pay nothing in capital gains tax. Those numbers then jump to 445k for a single filer and 501k for a married couple. If your income is below those thresholds, you fall into the 15% tax bracket on your capital gains. Above that, the cap on long-term capital gains is 20%
Do I owe capital gains tax if I sell my house?
Selling your home is a special case for capital gains tax. Selling your home is a special exclusion from paying these taxes, regardless of your income. If you have less than $250,000 in capital gains on the sale of your home, you pay nothing in taxes. The amount is increased to $500,000 for a married couple.
The special exclusion does not apply to investment properties. You can only avoid wealth tax if you sell your main residence and have lived there for two of the five previous years.
If your profit exceeds the thresholds, you only pay capital gains tax on the excess. So, for example, if you had a capital gain of $300,000 by selling your home as a single filer, you would only pay taxes on the excess $50,000.
How to Avoid or Minimize Capital Gains Tax?
Below are some tips and strategies you can use to reduce or avoid capital gains tax liability.
Invest for the long term
As mentioned before, if you hold an investment for more than a year, it is considered a long-term investment. Long-term capital gains are generally taxed at a lower rate than short-term capital gains. Keep your investment dates in mind and make sure you cross that one year threshold before selling something you don’t need to sell. By doing this, you can significantly reduce the capital gains tax you have to pay.
Using Tax Deferred Retirement Plans
Taking advantage of deferred retirement plans is another way to lower your capital gains tax rate. Retirement accounts like 401ks, IRA or 503bs are good examples. Even if you sell investments at a profit within these accounts, you will not be taxed on the capital gains. You don’t have to pay tax until you withdraw the money.
The idea here is that when the time comes when you need to withdraw money from your retirement accounts, you’ll be, well, retired. Typically, once you retire, your income drops and you fall into a lower tax bracket. So when you withdraw the money, you owe less capital gains tax.
Give your stock as a gift
Did you know that you can gift stock to a family member? It’s true. You can give up to $15,000 worth of stock to a family member. The strategy here would be to give it to a family member in a lower tax bracket than you. In this case, you can significantly reduce the amount of capital gains tax or even pay no capital gains tax at all.
You can also donate prized stock to charities to avoid paying capital gains tax. You also get the income tax reduction for the stock’s fair market value.
The laws surrounding both scenarios can change every few years, so always make sure you’re up to date with the latest news before trying any of these strategies.
Recognizing capital losses in taxes
We all love to talk about our investment gains, but don’t forget your losses, especially when it comes to tax time. If you sold investments at a loss, you must include them on your tax return to offset any gains.
For example, if you sold Share A for a gain of $20,000, but sold Share B for a loss of $5,000, you will only owe capital gains tax on the $15,000 of total gains by including both in your taxes.
Determine your cost base
When you’ve bought shares of the same stock or mutual fund at different times and prices, you’ll need to determine the cost basis for the shares you’re selling. Several methods can be used: last in, first out (LIFO), LIFO with dollar value, specific stock identification, and average cost (for mutual fund stocks only).
If you are selling a large amount of stock, consult a tax advisor to determine which method will reduce your capital gains tax the most.
Time for your sale
When it comes to selling stocks, timing can also be an important factor in paying capital gains taxes. I’m not just talking about long-term versus short-term investments. There may be a time in your life when you are experiencing financial difficulties or have reduced income for various reasons. When you have less income, it may be a better time to sell your investments, as you should be in a lower tax bracket.
Calculate your capital gains on the sale of your house correctly
When it comes to determining the capital gains on your home, there’s a little more to it than you might think. A good starting point is to take your selling price and subtract it from your original purchase price. However, you can deduct some closing costs, sales costs and the tax base of the property from your taxable capital gains.
Closing costs and selling costs are usually easy to determine and simple. The significant savings come from the tax base. Your tax base is the cost of any substantial improvements you made to your home while you own it. Anything that adds value to your home can be considered. However, it is reduced by any depreciation in that structure. For example, if you added a conservatory but then let it fall apart.
To put this into practice, let’s say you are single and bought a house for $150,000. You sell it for $500,000, and you have the following costs:
$15,000 in renovation $25,000 in brokerage fees $1,500 spent selling expenses (cleaning, set up, advertising, etc.) $3,000 in closing costs.
You would calculate your taxable capital gains as follows:
$500,000 – ($150,000 + $15,000 + $25,000 + $1,500 + $3,000) = $305,500
However, you still need to factor in the $250,000 special exclusion, so your final tax bill would be as follows:
$305,500 – $250,000 = $55,500
You only owe tax on $55,500 in capital gains. But as you can see, if you just made the sale price and subtracted the original purchase price and the exclusion, you’d be paying tax on a lot more in capital gains.
How To Avoid Capital Gains Tax – Final Thoughts
It seems that no matter how we make some money, we’re going to owe taxes on that income. It’s a bit unavoidable. However, that doesn’t mean we can’t do anything to lower those tax bills. When paying capital gains taxes, use some of the strategies above to maximize how much of your money you can keep.
Jeff is a fan of all things finance. When he’s not changing the world with his blog, you can find him on a run, playing a Mets game, playing video games, or just playing with his kids.
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