Capital Gains Tax Explained To Help Maximize Your Profit
Most of us know that we have to pay some type of taxes throughout the year. In April of every year, we have to file a tax return to make sure we paid enough taxes. That is a stressful time for many of us. Even when we have taken the right steps throughout the year, we still find ourselves incredibly stressed when it comes time to file taxes. There are some basic taxes of which we are all aware, but there are others we forget, or just do not know anything about. Those are the tax consequences that tend to sneak up on us. Continue reading this article to find out about one of those types of taxes and have capital gains tax explained.
What Are Taxes?
Before I get into the more complicated matters of capital gains tax explained, I want to start with the basics. If you are not aware of how regular taxes impact you, you are setting yourself up to owe a lot of money in April. Let's take a few moments to get familiar with taxes. The government charges everyone, individuals and businesses, fees on activities, income, property, expenses, and privilege. Just about anything and everything for which you can be taxed, you are. The money that is given to the government through taxes are then used in various areas, including, but not limited to, improving roads and the military. If you do not pay taxes, you are fined and potentially imprisoned.
There are some major categories of taxes that impact you:
Income Tax
Income tax is a tax that you pay on wages you earn. Depending on your tax bracket, the percentage of tax you pay changes. The more money you earn, the higher the percentage of taxes you pay. There are a few states that do not charge income tax, but other taxes within the state are higher.
Excise tax
is charged when you purchase specific items. This tax is added on top of sales tax so you could pay more than one tax on an item. These items are alcohol, tobacco, and gambling, including the lottery.
Sales tax
Sales tax is a tax on items you consume. The more you purchase then the higher the tax you have to pay. This tax is a percentage of the price of the item. Each state sets their percentage, so it differs from state to state. Often consumers use a barter system to eliminate paying this tax.
Property Tax
Property tax is paid on your home, any land you own, and other real estate. These taxes are used for sewage treatment, schools, and drinking water. When you are ready to purchase a home, you should pay attention to the property tax because that is going to be added into your total costs. This tax percentage also varies from state to state.
What Is Capital Gains Tax?
So I want to get right to it and explain what you really want to know. Here you will have capital gains tax explained. Capital gains is the term used to describe the money you make when you sell some type of investment for a profit.
An easy example is when you purchase stock at one price, but then sell it at a later date for a higher price. The capital gains is the actual amount of money that you earn, no matter how much or how little it may be. For example, if you purchase stock at $5 a share and you purchase 10 shares, you paid $50. You then sell it for $10 a share, so you make $100 on the sale. That is a profit of $50 and that is your capital gains. Any time you make a profit, that is shared with the federal government and then you are taxed on it.
It is important to understand the difference between realized and unrealized gains. You do not realize a gain until the investment is sold. It does not matter how much the investment appreciates, until you sell it. One benefit is that you do not owe any taxes until you actually sell the investment. Even though the value of the investment has increased, it is an unrealized gain for you. You do not actually have the money for it until you sell it and anything can happen between now and when you decide to sell.
Are There Different Types Of Capital Gains?
There are two main different types of capital gains and it benefits you to understand each of them. The two different capital gains tax explained are investments and real estate.
Investments
The most obvious investment is stock. I am sure you can figure that out, however, there are others of which you should be aware. Anything that can be considered an investment, not including real estate, can be hit with capital gains tax. If you purchase something as an investment and then turn around and sell it for a profit, most likely it falls into this category. If you are ever in a position where you are not sure, you should contact a professional to assist you and provide tax tips. In situations like this, you should always assume you are going to have to pay money. You may want to put some of your earnings aside for when IRS comes with a bill.
Real Estate
This is another important capital gain that you must understand. If you are in the real estate business, then real estate for you becomes a business profit and that is a different animal altogether. I am not going to focus on that now. Instead, I want to focus on those people that sell a house, or a piece of land and it is not your business. If you own one home and you sell it and then turn around and buy another home, you are typically exempt from capital gains tax because you used the money to buy a home.
However, you should contact a professional to help you navigate that. If you are flipping houses, so buying houses at a lower cost and fixing them up and selling at a much higher cost, you will probably have to pay capital gains. Unless, of course, you make it a business. Even so, you should talk to a professional to gain a clear understanding of how it impacts you at tax time.
Difference between Short Term And Long Term Gains Tax
When you are looking for capital gains tax explained, you should know about short term and long term gains. If you have not heard of these terms, you need to have some more information about then. Short term capital gains are those that you receive when you sell an investment in less than 12 months of buying it. If you buy stock, and sell it in 6 months, that is considered a short term gain. The really important part of this that you should know is that short term gains are taxed heavier than long term gains. The longer you hold on to an investment means that you are taxed less on it. Short term gains are considered taxable income, which is taxed at a higher rate, Long term capital gains are taxed at a lower rate, which could be anywhere from 0 to 20 percent. This rate is lower than the income tax rate. It may seem obvious to you, but long term capital gains are items that you sell after 12 months or longer after having purchased it.
Investing For The Long Term Saves Money
Based on the capital gains tax explained above, it probably makes a lot of sense to you that when you purchase an investment, you should plan to keep it for the long term. We all know that things can change quickly and while you may plan to keep an investment for a long time, you may have to sell it much sooner than you expected. There are also things that may happen outside of your control with the company in which you invested that might make you want to get rid of the investment quickly. If you have to do that and it results in a loss for you, then you do not have to worry about any type of capital gains tax.
Are There Tax Deferments I Should Know?
While I am in the process of capital gains tax explained, I also want to touch on tax deferments that may benefit you. When you invest money in a retirement plan, such as an IRA or 401k, that money grows and is not subject to taxes while it grows. The concept of retirement savings is you begin investing in it at a young age and you invest money on a regular basis. While you are continuing to invest money, that money is growing. You are able to buy and sell investments in any retirement accounts without you having to worry about any capital gains tax.
If you have a traditional account for retirement, any gains are taxed when you withdraw that money. However, at that point, you should be in a lower tax bracket because in theory you are not working and you are older, which changes your tax bracket. If you have a Roth account, the money is tax-free when you withdraw. There are, of course, rules that you must follow to ensure that your money is tax-free. If you have some other type of account that does not fall into the ones mentioned above, you may want to wait until you retire before you sell anything in that account. Again, if you have any questions, you should contact a professional tax advisor to get the answers to your questions.
Are There Other Deductions?
While this article provides information on capital gains tax explained, there are other deductions of which you should be aware. There are items that you can deduct from your taxes to help lower your tax liability. There are a good amount of them, but they do not all apply to everyone. There is a standard deduction that you can take, or you can choose to itemize your deductions. You cannot do both. I just want to touch on the common deductions for a moment so that you have some awareness of what is available to you.
Mortgage interest is a common deduction. You can only deduct the interest you pay. You cannot deduct the principal. If you purchased your home after the end of 2017, you are limited in how much interest you are able to deduct. State and local taxes are another deduction that you can take. This deduction includes property tax and sales tax. Charitable contributions can also be deducted, but if it is over $500 and not cash, you need to fill out an additional form. Medical expenses can also be deducted. Student loan interest up to $2,500 can be deducted. Keep in mind, this is only the interest that you pay on the student loans. It is not the full amount of your student loans.
What Are Capital Losses and Their Impact on Taxes
While this article is heavily focused on capital gains tax explained, it is just as important that you understand capital losses. Capital losses can be just as important when determining your tax liability as capital gains. It may make sense to you that capital losses is just that, a loss. That loss can work to decrease any gains on your investments. Keep in mind, you have to sell the investments in the same year for them to balance out each other. For example, you own several different stocks and you decide to sell two of them. One of them has increased your investment by 20 percent and the other one has decreased in value by 10 percent. The stock that decreased in value offsets the gains on the other stock. It will not completely offset it, but it will help defer some of your tax liability.
At the end of determining your taxes, if you have more losses than gains, you can use as much as $3,000 to offset any other typical income for the year. After the $3,000, you can carry the additional losses into future tax years until the losses have run out. It can get a little tricky when you have short term and long term gains in the same year. The different gains are taxed at different percentages. For an accurate idea of how the specific gains and losses impact your tax liability, you should contact a professional to help you and to ensure you are handling it properly. You want to make sure you stay within the law, but also do what is most advantageous to you.
Are There Other Ways To Save Money?
There are some other ways that you can save money on your taxes. This does not have as much to do with capital gains tax explained, however, these are important points for your consideration. When it comes to your taxes, make sure that you file them timely. If you do not file your taxes timely, you are charged fees and they can be hefty. IRS will also charge interest on top of any fees they charge. IRS is willing to work with you, but you have to follow the rules. That includes filing on time, or requesting an extension. That also includes paying your bill on time, or asking for a payment plan. If you ignore IRS or your taxes, they come after you hard. But, if you work with them, they will work with you.
Conclusion
There are some important takeaways about capital gains tax explained in this article. The first is when you sell an investment and earn money, you must pay taxes on it. The second is that you must understand the difference between short term capital gains and long term capital gains. Those two gains are taxed differently and if take that information away in this capital gains tax explained, I have done my job here. Another important takeaway is if you have any questions, do not assume you know the answers. You should reach out to a tax professional to find out for sure. They can help guide you to make sure you are following the law but also doing what is most advantageous to you. There are ways to pay less taxes than the IRS provides to you. Make sure you follow the rules and guidelines and you should be ok. And of course, do not try to do anything shady because IRS finds out eventually.