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Capital Gains Tax 101: A Beginner’s Guide to Understanding the Basics

Many people tend to forget about the capital gains tax when picking investments. While choosing the right mutual fund or stock can be tricky enough alone, it’s still vital to consider its consequences regarding taxes. Incorporating capital gains tax into your investment strategy will help you get the most out of it.

However, many individuals don’t have adequate knowledge about taxes, at least not enough to make a sound investment decision founded on the tax consequences. Fortunately, you can learn the basics of capital gains tax in our beginner’s guide and make a more informed decision or pinpoint areas where you might need professional help.

What Is the Capital Gains Tax?

When an investment is sold, an investor makes a profit, and the capital gains tax is a fee on that profit. An investor owes it for that tax year during which he sold the investment. Depending on the income, the long-term capital gains tax rates for 2023 are 0%, 15%, and 20% of the profit. However, some capital gains may be taxed at higher rates, such as gains on collectibles which are taxed at a 28% rate.

Investors owe long-term capital gains tax on the profits of investments that are owned for one year or more. If they own the investment for less than a year, they have short-term capital gains tax, which is determined by the ordinary income bracket. This tax is higher than the capital gains rate unless you’re the highest-paid taxpayer. Still, there are ways of minimizing capital gains tax, some of which we share below.

When Are Capital Gains Taxed?

The capital gain is taxed when it’s realized. Capital gains are typically realized for tax purposes when investors sell capital assets. Consequently, those assets can continue to increase in value without being taxed for the time you hold them.

Since you typically control the sale timing, you also choose the year of your taxable events. You may prefer to defer a sale for the following year for various reasons. For instance, you may want to save money, earn the interest, and pay your capital gains tax later, now that interest rates are rising.

Apart from sales, other events can also cause realization. For example, a home that’s involuntarily taken or converted by the government can be treated as sold. Capital gains or losses can also be realized in the case of property exchange.

However, different rules apply when it comes to like-kind real estate exchanges. For instance, you will have to find a replacement property during a specific period of time. Still, they might eliminate or at least reduce your taxable gains.

Home Sale Exclusion

When it comes to the sale of a primary residence, capital gains are taxed in a different way than other properties. If you have a capital gain after selling your primary residence, you can factor out up to $250,000 of that gain from the income.

However, you need to own it and live in it for at least two years out of the last five. The exclusion for married couples filing together is $500,000.

What Is the Difference Between Short-Term vs. Long-Term Capital Gains?

Long-term capital gains refer to the assets you hold for at least one year and are more favorable. On the other hand, short-term capital gains are returns on investments you hold for less than a year. Those are taxed at a higher, ordinary income tax rate.

How Does Capital Gains Tax Work?

You need to know the type and amount of capital gain (or loss) caused by the sale of the asset to calculate capital gains tax. Capital gain on the capital asset sale is the sale price minus the adjusted basis. Adjusted basis is the cost originally paid to purchase the asset (cost basis) plus additions minus subtractions.

Note that inheritances, gifts, and other similar exchanges are exceptions when it comes to calculating basis and identifying the capital gain type and have their rules. To determine net long-term capital gain (or loss), you need to subtract long-term capital losses from long-term capital gains. The same goes for short-term capital gains.

How to Reduce or Avoid Capital Gains Tax

If you want to reduce or avoid your capital gains tax, there are several ways to do that, such as:

Long-Term Investment

If you find an excellent company and hold its stock for the long term, you’ll be able to pay the lowest capital gains tax rate. However, a company’s luck may change in the future, hence you may need to sell it earlier than you initially planned.

Offset Gains with Capital Losses

You can use your investment loss by reducing the tax on the gains on your other investments. For example, you hold two stocks – one is worth more than what you paid for it, and the other is worth less. If you sell them both, the loss on one will decrease the tax you owe on the other stock.

In case your losses surpass your gains, you can use up to $3,000 of it to compensate for ordinary income for the year. Then, you can carry over the loss to the coming tax years until exhausted.

Be Patient and Wait It Out

If you bought a security about one year ago and want to sell it, make sure to discover the exact day of the buy. You may want to wait several days or even weeks in order to qualify for long-term taxes, as these are more favorable. However, the price of the investment should hold steady.

Make Sound Investment Decisions

After reading this article, you discovered the basics regarding capital gains tax. When choosing investments, it’s vital to consider your capital gains tax consequences to avoid financial struggles.

While taxes shouldn’t be your only consideration when investing, they should still be an essential part of your investment strategy. This way, you’ll be able to make wiser financial decisions and end up with more money in your pockets once payday comes.

Good luck!

Cher