Capital Gains Tax - Explained
What are Capital Gains Taxes?
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Table of ContentsWhat is a Capital Gains Tax?How Does Capital Gains Tax Work? Net Capital Gains Long-term vs short-term capital gainsCapital Gains Tax RatesLong-term Capital Gains RatesShort-term Capital Gains RatesCapital Gains Tax StrategiesHow to use capital losses to offset capital gainsHow to Generate Additional Capital Losses to Offset Capital GainsSpecial Considerations for Capital Gains TaxCapital Gains Tax and RetirementAcademics Research on Capital Gains Tax
What is a Capital Gains Tax?
Capital gains tax is a type of tax collected on capital gains that are profits earned from the asset sales such as stocks, metals, bonds, and property. The profit arises from ascertaining the difference between the selling price and the actual asset price, and the tax is imposed thereon. Though different nations have different tax laws, there are countries where investors are supposed to pay capital tax on capital income. For instance, Canadian tax laws ask investors to pay 50% of their marginal tax rate on capital gains earned. While the U.S. investors, both individuals and companies, are supposed to pay capital gain taxes on the net capital gains received every year. Any person who makes the sale of an asset, and reaps profit is bound to pay capital gains tax. However, rules dont apply to individuals such as day traders who are trading goods and services to earn a living, or on a daily basis.
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How Does Capital Gains Tax Work?
Capital gains tax takes place at the time of asset sale, and not when the investor is holding it. To be clearer, it means that the investor who owns stocks or shares for a year or any time period wont be liable for capital gains tax, until he or she sells them.
Net Capital Gains
It is not always the case that an asset value experiences appreciation. There can be times when there is a reduction in their value, and such instances are referred to as a capital loss. In case of a capital loss, the original price of the asset tends to be higher than the selling price. Net capital gains is the difference between the total value of capital gains and capital losses. So, an investor putting two stocks on sale in a year, selling one on a profit, and the other on a loss with same values would balance the amount of capital gain and capital loss made from the investment. Ultimately, the investor wont be liable for any net capital gains, or in short, wont have to bear any capital gains tax.
Long-term vs short-term capital gains
A long-term capital gain is the gain earned by an investor from selling an asset that was held for over 1 year prior to its sale. Whereas, a short-term capital gain refers to the gain earned on an asset that was held for a period less than 1 year. The same principle goes for short-term and long-term losses as well. It is easier for investors to calculate their final amount of net gain with their short-term and long-term gains and losses. The first step is to sum all types of gains and losses. An investor having four different short-term gains needs to sum up all of them for arriving at a final figure of short-term gains. The same approach goes for long-term losses, long-term gains, and short-term losses. After classifying and totalling gains and losses on the basis of short-term and long-term tenure, the next step is to deduct short-term gains from short-term losses, and find the net short-term loss or gain. And the similar concept goes for the long-term losses and gains. Then, the resultant numbers are subtracted from one another to arrive at a net value that is recorded on the tax return.
Capital Gains Tax Rates
The Internal Revenue Service, IRS, levies tax on every kind of capital gain. However, the rates for short-term and long-term gains may vary. (Note: Earlier, the tax rates of long-term capital gains were influenced by the tax brackets of the taxpayer. However, now the income levels of individuals determine tax rates).
Long-term Capital Gains Rates
Earlier, U.S. tax payers incurred taxes on long-term capital gains on the basis of the tax bracket they fell in. The ones falling in the lowest brackets ranging from 10% to 15% had no obligations for capital gains taxes, and the ones falling in the top bracket used to pay 20%. Now, the laws have changed, and with the introduction of Tax Cuts and Jobs Act, taxpayers need to pay long-term capital gains taxes on the basis of their income thresholds. According to 2019 laws, individuals earning up to $39,375 don't need to pay any taxes, the ones earning between $39,376 and $434,550 incur 15% tax, and the ones beyond $434,551 incur a tax rate of 20%. Married couples who file their taxes jointly don't need to incur any taxes for amounts up to $78,750, the couple earning between $78,751 and $488,850 pay 15% as tax, and the ones with a combined income of $488,851 and beyond pay 20% tax thereon. However, net capital gains can have tax rates between 25% and 28% in case they are a result of depreciated property or art.
Short-term Capital Gains Rates
Short-term capital gains have capital gains tax rate equivalent to the ones on income or other forms of ordinary income. When an asset is sold, capital gains arise. Capital gains and dividends received from an asset are not similar in nature. However, they signify profits derived from assets. In the United States, dividends get taxed under ordinary income. This applies to taxpayers who fall in tax brackets of 15% and beyond.
Capital Gains Tax Strategies
Taxes imposed on capital gains decrease the returns or profits earned from an investment. However, there is a legal approach followed by some investors for reducing or sometimes even eliminating any capital gains taxes for a fiscal year.
How to use capital losses to offset capital gains
For reducing the capital gains tax, taxpayers can utilize their capital losses for counterbalancing their capital gains. According to 2017 rule, when losses are more than profits, taxpayers can claim up to $3,000 loss amount against their earnings. When there is a roll over of losses, taxpayers can claim additional losses set against prospective earnings so as to decrease their taxes ahead. For instance, an investor gained $5,000 from selling securities, and then had a loss of $20,000 from the sale of shares. Here, he can use this loss in order to bring the capital gains for tax uses to zero. So, this means he can use the net loss of $15,000 for counterbalancing his income. Lets say, the original income of an investor was $50,000 in a fiscal year. In this case, he can use $3,000 that is the maximum claim, and decrease his income to $47,000 in order to save some of his taxes. Now, the remaining loss of $12,000 can be used for offsetting his income in the coming years.
How to Generate Additional Capital Losses to Offset Capital Gains
With the wash sale rule, taxpayers who know the essence of netting gains and losses can create more losses so as to net against the taxable gains. For example, the net short-term capital gain of Jerry is $800, the short-term capital loss is $2,350, the long-term capital gain is $3,800, and the long-term capital loss is $1,475. Subtracting the short-term capital gain and loss, Jerry will have a net short-term capital loss of $1,550, and similarly, a net long-term gain of $2,325. Now, he will deduct his long-term gain from short-term loss, and will arrive at a total net long-term gain of $775 which must be included on his tax return. However, Jerry could have paid less or zero taxable gain by taking stock of gains and losses prior to the end of the year he filed his return. And, he could have sold one more holding available at a loss. In case, he had another stock whose value fell by 50%, then he could have made its sale for realizing a tax deductible loss that he could have used to offset his gain or profit. For complying with the IRS wash sale policy, he could have bought back the stock after 1 month. The wash sale rule asks the taxpayer to buy back the similar stock after a minimum of 30 days which he or she sold in order to generate a loss. So, if Jerrys shares trade at a price that is $1,500 lower than the price he incurred, he has the option to sell them prior to the year end, and use the realized loss for nullifying his gain. Also, he can use the additional amount for excluding taxes from other income sources. Though net losses have a limit of $3,000 per year, any excessive amount can be used for deductions in the subsequent years.
Special Considerations for Capital Gains Tax
In most of the situations, people filing taxes need to include any capital gains arising from assets including personal assets, or security sale. As per IRS rules in 2017, a taxpayer receives an exemption of up to $250,000 on capital gains that are derived from selling a primary residence. This rule pertains to ownership and use tests that includes no claim on the second homes exclusion in the last 2 years, and living in the same house for a minimum of the last 2 years. For married couples, this exemption amount gets doubled to $500,000. There are no deductions offered on capital losses derived from selling the personal property. For instance, if an individual bought a home for a price of $200,000, and after a few years, realized capital gains of $300,000 by selling the home for $500,000 needs to file a capital gain tax on capital gains of $50,000 after excluding the exemption of $250,000. Mostly, repairs and maintenance expenses are also considered in the original cost of the home which ultimately decreases the capital gains.
Capital Gains Tax and Retirement
Investors who are about to retire may want to wait until they retire for selling assets, and earning profits thereon. In case, they have less retirement income, they may see less or even nil capital gains tax on their returns. However, if they already fall in any of the no-pay tax brackets, then it would be interesting to know that the amounts of big capital gains would raise their income to such an extent that they would be bearing taxes on the capital gains earned.
Academics Research on Capital Gains Tax
- Start-ups, venture capitalists, and thecapital gains tax, Keuschnigg, C., & Nielsen, S. B. (2004). Start-ups, venture capitalists, and the capital gains tax.Journal of Public Economics,88(5), 1011-1042. A model of start-up finance with double moral hazard is proposed. Entrepreneurs have ideas and technical competence, but lack own resources as well as commercial experience. Venture capitalists (VCs) provide start-up finance and managerial support. Both types of agents thus jointly contribute to the firm's success, but neither type's effort is verifiable. We find that the market equilibrium is biased towards inefficiently low entrepreneurial effort and venture capital support. In this situation, the capital gains tax is particularly harmful. The introduction of a small tax impairs effort and advice and leads to a first-order welfare loss. Several other policies towards venture capital and start-up entrepreneurship are also investigated.
- Capital gains tax policy toward entrepreneurship, Poterba, J. M. (1989). Capital gains tax policy toward entrepreneurship.National Tax Journal,42(3), 375-389.
- Capital gains tax rules, taxloss trading, and turnoftheyear returns, Poterba, J. M., & Weisbenner, S. J. (2001). Capital gains tax rules, tax loss trading, and turn of the year returns.The Journal of Finance,56(1), 353-368. Changes in the capital gains tax rules facing individual investors do not affect the incentives for window dressing by institutional investors, but they can affect the incentives for yearend tax induced trading by individual investors. Empirical evidence for the 1963 to 1996 period suggests that when the tax law encouraged taxable investors who accrued losses early in the year to realize their losses before yearend, the correlation between early year losses and turn of the year returns was weaker than when the law did not provide such an early realization incentive. These findings suggest that tax loss trading contributes to turn of the year return patterns.
- Tax evasion and capital gains taxation, Poterba, J. M. (1987). Tax evasion and capital gains taxation.
- Measuring permanent responses tocapital-gains taxchanges in panel data, Burman, L. E., & Randolph, W. C. (1994). Measuring permanent responses to capital-gains tax changes in panel data.The American economic review, 794-809. We use panel data and information about differences in state tax rates to separate the effects of transitory and permanent tax rate changes on capital-gains realizations behavior. The estimated effect of permanent change is substantially smaller than the effect of transitory change. The difference is even larger than differences between estimates from past micro data studies, which have primarily measured the transitory effect, and time-series studies, which have primarily measured the permanent effect. Our results resolve a long-standing conflict between micro data and time-series studies of how marginal tax rates affect capital-gains realizations behavior.