Selling Something? Be Aware of Capital Gains!

What is a Capital Gain?

A capital gain is the increase in an asset’s value (a mutual fund, your practice, even your home) from the time you acquired it to the time you sold it. In other words, your capital gain is your profit.

The IRS collects taxes on capital gains depending on how long you’ve owned the asset. Different tax rates are applied to short-term capital gains (gains on assets held less than one year) than are applied to long-term capital gains.

A capital gain is the increase in an asset’s value between the time you buy it and the time you sell it. If you sell a capital asset for more than you bought it for, you’ve experienced a capital gain. On the other hand, you experience a capital loss when you sell something for less than you bought it.

The IRS uses what’s called an adjusted basis to determine if there’s been a capital gain. In most cases, the adjusted basis of an asset is simply the amount it costs you. If you have used financing to purchase the asset, the balance of the loan at the time of the sale will affect the amount of cash you receive from the sale but it will NOT affect the amount of the capital gain.

How Capital Gains Works

Imagine that you bought 10 shares of stock in your favorite company, with each share valued at $100. One year later, the stock’s price has increased to $120, and you decide to sell. While you bought the stock for a total of $1,000 ($100 x 10 shares), you were able to sell it for $1,200 ($120 x 10 shares). You’ve experienced a capital gain of $200, which will be subject to capital gains taxes.

It’s also possible to experience a capital loss, which is when you sell an asset for less than you bought it for and that loss exceeds any capital gains you had that year. When you have a capital loss, the IRS allows you to deduct up to a certain amount (only $3,000 for 2021) to reduce your taxable income for the year.

Capital gains and losses don’t just apply to the property you buy. If someone gifts you something of value and you sell it for more than it was worth when you received it, your gain could be subject to capital gains taxes.

Capital Gains and Mutual Funds

Capital gains work a bit differently when it comes to mutual funds if they are held in a non-retirement account. Unlike other assets, you don’t have capital gains only when you sell your shares.

Throughout the year, mutual fund managers buy and sell shares and pass earnings along to the fund shareholders in the form of distributions. Even if you reinvest these distributions, they’re still considered capital gains and will be subject to capital gains taxes. Because these transactions occur throughout each year, distributions will likely be considered short-term capital gains.

Types of Capital Gains

The IRS categorizes capital gains into two different categories: short-term and long-term.

Short-Term Capital Gains - Gains on assets held for one year or less. Taxed as regular income.

Long-Term Capital Gains - Gains on assets held for more than one year. Taxed at 0%, 15%, or 20% depending on taxable income

The big distinction between short-term and long-term capital gains comes down to how long you owned an asset before you sold it. While this difference might not seem significant, it really is when it comes to the tax rate you’ll pay. Most people will pay a considerably lower tax rate on long-term capital gains.

How Much Is the Capital Gains Tax?

Short-term capital gains are taxed as regular income. For 2021, the income tax brackets range from 10% to 37%.3. The U.S. has marginal tax brackets, meaning each portion of your income is taxed based on the bracket it falls into. Depending on how much you earn from other income sources, your short-term capital gains could push some of your income into a higher tax bracket.

Long-term capital gains are taxed differently than the rest of your income, and typically at a lower rate. There are three long-term capital gains tax rates for most individuals: 0%, 15%, and 20%.

Long-Term Capital Gains Tax Rates for Tax Year 2021

Capital Gains Tax for Married Filing Jointly

  • 0% for up to $80,800 in taxable income.

  • 15% for taxable income between $80,801 to $501,600

  • 20% for taxable income over $501,601

Key Takeaways

  • A capital gain is the profit you earn when you sell an item for more than you bought it.

  • The IRS classifies capital gains as either short-term or long-term. Short-term capital gains come when you own an asset for one year or less. Long-term capital gains apply when you hold an asset for more than one year.

  • Capital gains are subject to taxes, and the tax rate depends on your annual income and whether it was a short-term or long-term capital gain.

  • Capital gains work differently for mutual funds since you could experience and pay taxes on gains without selling your shares.

  • Work with your CPA to manage your capital gains and losses BEFORE you sell the asset.

Jeff Gullickson