Real estate, stocks and bonds, are a few examples of investments we choose to make in the hope of gaining some profit at some point in the future. When you sell those stocks or real estate, however, the federal government will be waiting to take its share. This is known as the “capital gains tax.” Understanding the capital gains tax, and how the IRS calculates it, can be helpful in finding ways to lower the amount of capital gains tax you might own when you sell those valuable investments or other assets.
When the capital gains tax is assessed
If the sale price for an asset is higher than the initial purchase price (in other words, there is a profit), the IRS calls that a “capital gain.” For example, you bought a diamond pendant for your wife on your anniversary for $2,500. Five years later, you later sell the ring for $3,500, so your capital gain is $1,000. At that point, the government will impose a tax that is a percentage of your capital gain. The tax is only imposed, though, when the capital gain is actually “realized,” or actually sold. This means that, because your assets increase in value, but have not been sold, the capital gain has not yet been realized and will not be taxed.
Which assets are taxable?
A capital gain is only imposed on the sale of a “capital” asset. This term is very broadly defined by the IRS as “almost everything you own and use for personal or investment purposes.” The most common taxable assets are securities, real estate and valuable collectibles. If you sell real estate or other property, either for personal or business purposes, and profit from the sale, that qualifies as a capital gain, as well.
The tax rate that is applied to the sale of real estate will depend on whether the property was for business or personal use. An individual taxpayer is allowed to exclude up to $250,000 in capital gains from the sale of a primary residence. That amount is doubled for a married couple. Remember that a primary residence can also include a trailer or houseboat.
How can to Lower Capital Gains Taxes
Although making short-term investments, with higher interest rates, may seem like the smart move, after the capital gains tax is imposed, you will likely have much less profit than you expected. One of the common ways to lower capital gains taxes is to avoid short-term investments. Long-term investments nearly always have a lower tax rate. If you fall in the lowest tax bracket, you will likely pay no taxes on long-term capital gains.
Another good way to lower your capital gains tax is to shelter as much of your income as you can in tax-deferred retirement accounts. Retirement accounts, such as 401(k)s, Roth IRAs and Traditional IRAs are great examples of accounts that you can buy, sell and exchange within the account itself. That way, you will not be assessed a capital gains tax. For this reason, retirement accounts can provide shelter from the capital gains tax for your investments, as long as the money earned from the sale continues to be reinvested into another security.
If you have questions regarding capital gains, or any other estate planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.