What Is Capital Gains Tax: How It Works and How to Reduce It

Capital gains tax is the tax you pay on profits from selling investments. However, many investors are caught off guard by unexpected tax bills when they realize gains from assets like stocks or real estate.

These tax bills can not only be confusing, but they can also burn through your investment returns if you don’t understand capital gains tax.

In contrast, learning how capital gains tax works can help you make smarter investment decisions and ultimately reduce your tax burden.

In this article, we’ll look into capital gains tax examples, differentiating between short-term and long-term capital gain. In addition, we’ll explain how to report and calculate capital gains tax in the United States, concluding with a few helpful tips on minimizing it. Let’s begin!

Key Takeaways

• Capital gains tax is the tax you pay on profits you make selling investments such as real estate, stocks, business assets, or personal property.
• Tax rates on capital gains usually don’t exceed 15%, although they can be 0% for lower taxable incomes and 20% for higher taxable incomes.
• If you sell an asset within a year of buying it, your profit will be taxed at a short-term capital gains tax rate. Alternatively, if you hold on to the asset for more than a year, your gain will be taxed at a long-term rate, which is usually lower.
• You need Schedule D to report capital gains tax.
• Certain assets, like primary homes, may qualify for a capital gains tax exclusion. Meanwhile, other assets, such as those transferred between spouses, may be free from capital gains tax altogether.

What Is Capital Gains Tax and How Does It Work?

Capital gains tax, a type of investment tax, is the tax you pay on profits (capital gains) from selling investments such as stocks, real estate, or cryptocurrencies, with crypto taxes falling under the same rules. The act of selling these assets is called “realizing a gain,” and the tax doesn’t apply to unsold investments (unrealized capital gains), no matter how much their value has increased.

That said, capital gains tax only applies if you sell an asset for more than you paid when you bought it. In other words, if you sell it for less than you spent on it, that’s a capital loss, and it’s not taxable.

To sum up, capital gains tax only comes into effect when you sell an investment for a profit, which is how it differs from other types of taxes.

For example, income tax applies to money you earn from your job, like wages or salaries. Meanwhile, dividend taxes apply to money you get from stock dividends, and interest tax is the tax on the income generated from saving or lending money.

How Does Capital Gains Tax Work?

Capital gains tax depends on your taxable income and filing status, as well as what asset you sold and how long you held it.

It’s applied to the difference between the amount of money you paid for the asset and the profit you made selling it. For example, if you bought a stock for $1,000 and sold it for $1,500, the difference is $500—that’s your capital gain.

The tax rate on net capital gains usually doesn’t exceed 15%, but it depends on your tax bracket. For instance, the rate is 0% for taxable incomes that are lower or equal to the following amounts:

• $47,025 for single people or married couples filing separately
• $94,050 for married couples filing jointly and qualifying surviving spouses
• $63,000 for heads of household

Taxable incomes above these thresholds but below or equal to the following are subject to the most common rate of 15%:

• $518,900 for single people
• $291,850 for married couples filing separately
• $583,750 for married couples filing jointly and qualifying surviving spouses
• $551,350 for heads of household

Finally, the 20% rate applies to taxable incomes exceeding the thresholds established for the 15% rate. That said, here are some cases where the rate can exceed 20%:

• Profits from selling qualified small business stock are taxed at a maximum rate of 28%
• Gains from selling collectibles are also taxed at a maximum rate of 28%
• Gains from selling certain real estate are taxed at a maximum rate of 25%

Short-Term vs. Long-Term Capital Gains

If you sell an investment you’ve owned for a year or less, your profit is considered a short-term capital gain.

On the other hand, if you’ve had the asset for more than a year, the profit on its sale is a long-term capital gain and is usually taxed at a lower rate.

With this in mind, if you sell a stock within a year of buying it, it’s taxed at the short-term capital gains tax rate, which is the same as your regular income tax rate (10% to 37%). In contrast, if you hold it for more than a year, it’s taxed at the long-term capital gains tax rate (0% to 20%).

What Assets Are Subject to Capital Gains Tax?

Here are the assets that are subject to capital gains tax:

• Stocks and investments. Profits from selling financial assets such as stocks, mutual funds, or exchange-traded funds (ETFs) are taxed. This goes for most investments you buy with the intention of making money in the long run.

• Real estate. If you sell a property, like a house, apartment, or rental property, for more than you paid for it, the difference is subject to capital gains tax.

• Business assets. If you sell assets from your business—like equipment, inventory, or intellectual property—anything you earn is taxed. This applies to all businesses, small and large, as well as private companies.

• Personal property. This includes assets like cars, jewelry, or art you sell to make a profit. As always, the gain is taxed if it’s higher than what you paid for the item, although personal property isn’t taxed as often as real estate and stocks.

Capital Gains Tax Exclusion, Exemption, and Allowance

If you’re selling your primary home, you can leave out a part of your profit from being taxed. This is a capital gains tax exclusion, and you can qualify for it if you’ve lived in the home for at least two of the last five years. The portion you can exclude goes up to $250,000 for single people and up to $500,000 for married couples filing jointly.

That said, certain assets are completely free from capital gains tax—they fall in the capital gains tax exemption category. These include assets transferred between spouses, gains you make from selling municipal bonds, and profits from a Roth IRA (if you’re at least 59 and a half years old and have had the account for a minimum of five years).

Lastly, some countries, like the UK, have an annual capital gains tax allowance. Simply put, if your total capital gains for the year are below that amount, you don’t pay any tax.

How to Calculate Capital Gains Tax

To calculate capital gains tax, you first need to figure out the purchase price, i.e., how much you paid for the asset, including extra costs like transfer and escrow fees. Then, determine the selling price and subtract the purchase price from it. For example, if you bought a piece of real estate for $200,000 and sold it for $250,000, your capital gain would be $50,000.

At this point, you need to apply the relevant tax rate. If you’ve owned the asset for a year or less, it’s a short-term capital gain and thus taxed at your regular income tax rate. However, if you’ve owned the asset for over a year, it’s a long-term capital gain, and you’ll pay tax for it at the 0%, 15%, or 20% rate, depending on your income.

Let’s say you make between $47,025 and $518,900 a year as a single person. In this case, your long-term capital gain will be taxed at the 15% rate. If we use the real estate example mentioned above, you’ll pay 15% of $50,000, which is $7,500. To streamline the whole calculation process, you can use a tax calculator, where you’ll enter information like purchase and selling price, holding period, and your income.

Now, for the special considerations—they come into play if you’ve claimed depreciation on property, as this portion of your gain may be taxed at a higher rate, usually up to 25%. While owning a property, depreciation lowers your tax liability, but when you sell, you may have to recapture some of that depreciation.

For instance, if you buy a property for $200,000 and claim $10,000 in depreciation, the property’s tax value will be $190,000. If you then sell the property for $250,000, your gain will be $60,000, but $10,000 will be considered depreciation recapture and taxed at the 25% rate.

How to Report Capital Gains Tax

To report capital gains tax, you’ll need Schedule D in addition to Form 1040. Detail your profits and losses from selling assets like stocks, real estate, and other investments on Schedule D, and use Form 1040 to report your total income, including capital gains.

When you sell an asset, the company or platform you used should send you a 1099 form to show how much you’ve made from the sale. You’ll use this information to fill out Schedule D.

If you’re juggling multiple sources of income, Paystub.org offers user-friendly tools like a 1099 generator that can help you track your freelance earnings and a pay stub generator that is useful for other non-investment income.

Lastly, if you work a part-time or a full-time job on top of freelancing, you can use our W-2 form generator to report your wages on your 1040.

4 Ways to Minimize Capital Gains Tax

Some of the ways you can minimize capital gains tax include strategic selling and long-term holding.

Let’s explore these tax-saving strategies in detail:

#1. Strategic Selling

You can lower your capital gains tax if you plan when to sell your assets. For example, choosing a year when your income is lower can place you in a lower tax bracket and reduce your tax rate. Moreover, timing your sales to offset gains with losses may give you potential tax benefits, such as reducing your taxable income and lowering your capital gains tax rate.

#2. Tax-Loss Harvesting

One way you can offset gains from profitable sales is by selling investments that have lost value. This way, you’ll reduce your overall taxable income and lower your capital gains tax by extension. You may even qualify for tax deductions if your losses exceed gains.

#3. Using Tax-Advantaged Accounts

Investing through accounts like IRA or 401(k) offers tax benefits. In traditional accounts, you defer taxes until you withdraw funds. Roth accounts are even more advantageous—they allow for tax-free withdrawals for people over 59 and a half who have had the account for at least five years.

#4. Long-Term Holding

Holding onto investments for more than a year before selling qualifies you for long-term capital gains tax rates, which are lower than short-term ones. This simple strategy can save you money on taxes and maximize your returns.

Capital Gains Tax Special Considerations

When it comes to capital gains tax, there are a few special considerations to keep in mind. For example, if you inherit a property, you won’t pay capital gains tax on any increase in value that happened before you inherited it, thanks to the stepped-up basis tax policy. For gifted property, though, you take on the original owner’s cost basis.

Additionally, as previously mentioned, if you sell your primary residence, you qualify for an exclusion of up to $250,000 in gains if you’re single or $500,000 if you’re married. That is if you’ve lived there for at least two of the last five years.

That said, don’t forget about state taxes—many states impose their own capital gains taxes. Lastly, certain assets, such as collectibles, have special tax rates, which are usually higher.

Final Thoughts

Knowing the answer to the “What is capital gains tax?” question when selling assets helps you calculate exactly how much you owe and whether you qualify for a tax exclusion or even exemption.

Even if you don’t, you can make the most out of your sales with smart tax planning. Timing is everything—choosing when to sell can make a significant difference in how much tax you’ll pay.

That said, the best strategy you can employ is to seek professional help. With expert advice, you can reduce your tax burden and ensure you’re taking full advantage of available opportunities.

What Is Capital Gains Tax FAQ

#1. What is an example of a capital gain?

An example of a capital gain is the profit you make selling real estate. Let’s say you buy a house for $200,000 and sell it for $250,000. The difference between the purchase and selling price (in this case, $50,000) is a capital gain.

#2. Do I have to pay capital gains tax on stocks?

You have to pay capital gains tax on stocks if you sell them and make a profit. However, if you sell an asset for less money than it cost when you bought it, that’s a capital loss, which isn’t taxable.

#3. How can I avoid capital gains tax on real estate?

You can partially avoid capital gains tax on real estate if you sell your primary home on the condition that you’ve lived there for at least two of the last five years. To be specific, you can exclude $250,000 ($500,000 for married couples).

#4. What is the capital gains tax rate for 2024?

The capital gains tax rate for 2024 ranges from 0% to 20%, depending on your income. That said, profits from certain assets, like collectibles, are taxed at higher rates.

#5. Are cryptocurrencies subject to capital gains tax?

Cryptocurrencies are subject to capital gains tax if you sell them and make a profit. However, if you simply have them in your possession, capital gains tax doesn’t apply to them.

#6. How do capital gains affect my tax bracket?

Capital gains can affect your tax bracket if they push your total taxable income above a certain threshold. Namely, you report them on Form 1040, making them a part of your overall income.