If you recently sold assets that you purchased for investment, such as a stock, bond or mutual fund — even real estate — and you sold it for more than you paid for it, you will more than likely owe income taxes on that capital gain.
The United States has been taxing capital gains in one way or another since the income tax originated in 1913. At various times during the twentieth century, the Internal Revenue Service (IRS) had rules that excluded a portion of long-term capital gains or applied a special tax rate to capital gains. In fact, for most of the history of the income tax, long-term capital gains have been taxed at a rate lower than ordinary income.
How the capital gains tax works
The taxation of capital gains depends on how long you have owned the asset you sell. Short-term capital gains, which occur on property you have owned for one year or less, are fully taxable as ordinary income (no favorable tax rate). Special long-term capital gains rates apply to property you have held for longer than one year. In 2019, long-term capital gains are taxed at 0%, 15% or 20% depending on how much total income a person has earned.
Here is an example of how the holding period works. If on January 23, 2019, you have a stock-based mutual fund you want to sell, you would have had to have owned that fund since January 22, 2018, for long-term capital gains tax rates to apply. If you bought it on July 16, 2018, instead, then any gain would be short-term.
Handling capital losses
Of course, when you sell any security there is a chance that you will incur a loss instead of a gain. If that happens, special rules apply for tax purposes.
First, you use short-term losses to offset any short-term gains, and long-term losses against long-term gains. Only then can you offset short-term against long-term. If your transactions for the year still show a loss, you can take a deduction of up to $3,000 for the year. If your loss is greater than $3,000, then you may carry the balance over to the next income tax year. Whether the carryover is short-term or long-term will depend on the result of netting short- and long-term gains and losses against each other.
Now that you know the rules, calculating your capital gain is fairly simple. Let’s say you bought 100 shares of XYZ stock for $1,000 on May 5, 2014. At the time, you paid a $25 commission to make the purchase. Your cost basis would then be $1,025. Five years later, you decide to sell the stock for $5,000 and also pay a $25 commission to make the sale. That means your proceeds are $4,975. Your long-term capital gain on this transaction is $3,950 — which you calculate by subtracting your $1,025 cost basis from your proceeds of $4,975.
How does it work when you have multiple transactions? Assume that Cindy sold three mutual funds during 2018. On the first transaction, she made a short-term profit of $1,800. On the second transaction, she had a long-term loss of $4,500. And on the third she had a long-term loss of $2,850. Cindy has a net short-term gain of $1,800 in 2018 and a net long-term loss of $7,350. When filing her taxes, Cindy will want to offset the gains and losses against each other. This reduces her net loss to $5,550.
For 2018, the federal income tax law allows Cindy to take a $3,000 deduction against her other income from things like salary, interest and dividends. That leaves her with a long-term loss carryover to 2019 of $2,550. Cindy will report all of her gains and losses on Schedule D of her 2018 Form 1040.
Special exceptions to watch for
Special rules apply to certain capital gains transactions. Any gain you incur on the sale of art and collectibles, for example, are taxed at ordinary income tax rates up to 28%. You can also exclude up to $250,000 in gains ($500,000 if married) on the sale of a principal residence if you meet certain conditions, including having lived in the property as your primary residence for two of the last five years before the sale.
5 strategies to minimize what you’ll owe
There are a number of helpful strategies investors may want to follow to try and minimize capital gains taxes.
1. Don’t sell
The best way to keep from paying capital gains taxes is to follow a long-term buy-and-hold strategy. Choose investments with the potential to grow over time, then save your money for a future goal such as retirement.
Spotting a buy-and-hold investment isn’t easy. If it is an individual stock, look for a company with a strong history of profits, a solid dividend and management with a track record of producing profits for investors. If you are investing in mutual funds, information is available on how the fund has performed over time. Also look at the track record of the fund manager. A history of doing well in all kinds of market conditions means this is an investment that might have a long-term place in your portfolio.
2. Invest in tax-advantaged vehicles
Tax-advantaged investments include things like individual retirement accounts (IRAs). Traditional IRAs are tax-deferred, meaning you don’t pay any tax until you withdraw money from the account, usually at retirement.
If you own a mutual fund in your IRA and you sell it at a gain, you don’t pay any taxes; you simply reinvest the proceeds in another investment. At retirement, you pay taxes at ordinary income tax rates.
Roth IRAs operate similarly, except you contribute after-tax dollars today and don’t pay any taxes on money you withdraw later, provided you are over age 59½ and the account has been in existence for at least five years.
3. Follow a tax-matching strategy
As noted earlier, any capital losses you incur first offset any capital gains with the same holding period. Then you offset short-term against long-term to get a final result.
If you sell something and incur a large gain, it’s time to do a little tax loss harvesting. That doesn’t mean you sell something just because it shows a loss, but ask your CPA or investment advisor to help you look through the portfolio. If you own a stock that has showed a loss for virtually the entire time you have owned it, selling it to minimize the tax impact of a capital gain might be a good idea.
Ann Reilley Gugle, a certified financial planner at Alpha Financial Advisors in Charlotte, North Carolina said that her firm uses two software programs to help clients match up gains and losses. Throughout the year she says Alpha uses a tool “trying to look for tax-loss harvesting opportunities.” Gugle said it is especially important to look for potential losses all year long. While 2018 had many loss opportunities, she emphasized that is not the case in every year.
The second software program Alpha uses identifies the capital gains distributions mutual funds will make and the “record date” (the date you have to own the fund to receive the distribution). Depending on the size of the distribution and how much of the fund the client owns, the advisors at her firm will “consider selling it temporarily and buying a comparable exchange-traded fund,” Gugle said. After waiting 30 days to avoid the wash-sale rule, they will rebuy the same fund and, of course, avoid having to pay tax on the capital gain distribution.
4. Donate appreciated property to charity
One thing you can do with securities that show a gain is to “give away” the gain to charity. Let’s say you make a donation to the same charity every year — perhaps the college you graduated from. Instead of making a cash donation, why not donate stock or a mutual fund instead?
Securities that have shown a significant gain can make great candidates for donation. You get the same charitable deduction you would have if you had donated cash, but you won’t have to pay tax on the gain. Plus, you get to keep the cash you would have donated. It’s a win for both you and the charity.
5. Strategically balance gains and losses
In addition to harvesting losses to offset a large gain, investors can pursue a broader strategy each year of selling some securities with a loss and some with a gain with the idea of offsetting one against the other. Why carry a loss into the next tax year? Instead, sell a security at a profit that you were thinking of selling anyway. That way you get immediate benefit from the loss instead of having to wait 12 months.
Gugle also cited a special situation for investors with especially large gains. They may want to consider investing in property within an Opportunity Zone, created by the Tax Cuts and Jobs Act in 2017. Gugle said taxpayers with an investment gain from property in a state-designated Opportunity Zone can defer tax on that gain. By owning the property long enough, Gugle said “the gain becomes part of your investment.”
Investors should continue to pay careful attention to the tax ramifications of the transactions they make. This includes managing capital gains, matching them with losses and looking for opportunities to give those gains away to charity. By doing so, investors can keep the capital gains taxes they pay as low as possible.