A Perfect Explanation of Long-Term Capital Gains Tax?
Tax season is just around the corner and with it comes questions- especially if you have experienced something new in life. One of these questions- or maybe 100 of them- revolves around the tax on capital gains. And with good reason- it can get really confusing.
We know that which is why we are providing the information you need to understand this tax a little better. If there is still any confusion, you may want to speak directly to an accountant about your personal situation. However, this information will, at the very least, help you decide what you need to ask and what direction you need to take the conversation. Let’s get started.
What are Capital Gains?
We are going to skip the official financial jargon and keep this really simple. Capital gains refer to the money you make when you sell an investment for a profit. Let’s say that you purchase stock. Later, you decide to sell it. If you sell it for more than you bought it, you have capital gains.
Your capital gains are the amount of profit you made, be it $10 or $10,000. Unfortunately, you can’t make a profit without sharing it with the government, even if it is just a few bucks. The federal government taxes you, of course, but you will also often be taxed by your state government. Before we get into that, though, let’s understand a little more about what requires you to pay a capital gains tax.
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Types of Capital Gains
There are two basic categories that require capital gains taxes to be paid: investment and real estate.
Investment Assets
Of course, this includes stocks, but it does not end there. Anything that you purchase as an investment that you later to sell to another investor for a profit is considered an investment asset. This is one of those places that capital gains can get a little tricky.
If you have sold something that you are just unsure about, it is always best to set your mind at ease by speaking to a professional about that particular item. It is usually best, though, to take my life advice here: hope for the best but prepare for the worst. Maybe your item will be exempt, but go ahead and plan to have to pay a tax. Then, the only real surprise you get is if you find out you do not have to pay.
Real Estate
Real estate can be a little tricky, too. As we will discuss in a moment, if real estate is your business, your gains should be considered strictly business profit. So who, exactly, gets taxed on capital gains from real estate? Many homeowners will get taxed on capital gains from the sale of their own homes. However, many homeowners can get an exemption from this tax under certain circumstances. Your tax professional can help you with determining if you will be eligible.
Those who are flipping a home here and there are the most likely to have to pay capital gains taxes on real estate, unless you turn it into a full time business. Like I said, it can get a bit confusing with the real estate property, so it often takes speaking to a professional regarding your particular situation, property, and profit.
What if the Gains are Attached to My Business?
This really depends on the type of business you run. If your business deals specifically in that type of asset, your profits are actually income, not capital gains. For instance, real estate developers who make a profit are actually making an income. Pawnbrokers and gold dealers are typically the same.
Capital gains more often apply when it is a personal profit, not a business one. However, if you are uncertain, speak to your accountant. If you do not have one, you can often get no cost or low cost consultation with some- that’s their way of attracting new clients.
What is the Difference in Short Term and Long Term Capital Gains?
If you are looking into capital gains, you have probably heard of both short term and long term capital gains. And, most likely, you are wondering what qualifies as each. In truth, this is probably the easiest part of capital gains to understand.
Short term capital gains are what you make from selling investments in less than 12 months. For instance, if you buy stocks and sell them in four months, it falls under short term capital gains. Anything over 12 months is considered long term capital gains. Why, exactly, is this important to you?
Well, let’s put it this way: the longer you hang onto something, the lower the tax rates. Short term gains are treated and taxed just like your taxable income, which can get pretty high. As of 2019, long-term capital gains tax rates are anywhere between zero and 20%, which is usually much lower than taxable income rates.
Realized VS Unrealized Gains
There are also realized and unrealized gains to understand and, fortunately, this is not too difficult of a section either. Realized gains are simply gains you have actually already gained. In short, if you have decided to sell your home but have not actually received the cash yet, the gains are not yet realized. When you have actually received the money, they become realized gains.
Under almost all circumstances, long-term capital gains tax is not added until the gains are realized. It is important to know that gains are different from dividends. If you are earning dividends from stocks, you get taxed on these the entire time you are earning them. The long-term capital gains tax does not kick in until you sell the item and receive the payment.
Long-Term Capital Gains Tax
Now that there is an understanding of capital gains and the difference between short term and long term capital gains, let’s move onto the long-term capital gains tax. Again, if you make money, you have to pay taxes on it, including the profits you make selling items. Anything that you have sold after 12 months is subject to a long-term capital gains tax.
The question now becomes how much can you expect to pay. Of course, there is no certainty until you actually have your taxes done, but there are some guidelines that can help you get a good idea.
How Do I Know What I Will Have to Pay?
Everything is subject to change when the government sees fit, and your particular situation may add or take away from things. However, the following will give you a very basic idea of what you might expect:
| Tax-filing status | 0% tax rate | 15% tax rate | 20% tax rate |
|---|---|---|---|
| Single | $0 to $41,675 | $41,676 to $459,750 | $459,751 or more |
| Married, filing jointly | $0 to $83,350 | $83,351 to $517,200 | $517,201 or more |
| Married, filing separately | $0 to $41,675 | $41,676 to $258,600 | $258,601 or more |
| Head of household | $0 to $55,800 | $55,801 to $488,500 | $488,501 or more |
Do be aware that the higher your tax bracket, the higher the chance that you will be paying other taxes as well, so do not be surprised to be charged more.
What If I Do Not Make a Profit or I Lose Money Instead?
Nothing really happens if you break even, or sell at zero profit. However, if you lose money, we have some good news. First off, you do not have to worry about paying taxes. That is good in and of itself, but there is a little more good news: a capital loss just might help you out next year.
Here’s the thing: capital losses from your investments can actually reduce your annual taxable income by $3,000 per year. So, if your capital loss is $3,000, that is simply subtracted from your taxable income for that year, meaning you really are not losing out too much.
What happens, though, if your capital loss is $6,000? Do you still lose out on that other $3,000? Nope. You can actually carry any loss above $3,000 over to the next year to help offset capital gains and taxable income. What this means is that, though it may be disappointing to lose out on a big profit, you really do not lose too much. The disappointment is typically the biggest cost.
What is the Point of Taxes?
Taxes really can seem like an inconvenience and- yes- unfair. We work hard for our money, right? Why do we have to pay someone else after we have worked so hard for what we have? People really do not like paying taxes, especially when it is going to things that may not seem to benefit us. And, of course, many people hate paying taxes into social welfare programs that sometimes looks like it is allowing others to not work.
Is it Fair to Pay Taxes?
I have heard it all, even from my own family and some acquaintances. Many feel that if they can work for what they have, others should have to, too. Here’s what I have to say to all of that: No, I cannot speak for every American citizen and, yes, there are always people that take advantage of things. What I can say is that this is not the case with everyone.
Some people truly have a hard time and very legitimate reasons for needing this assistance. So, before I get deep into the purpose of taxes, I want to paint a picture to try to open up some minds and- hopefully- help some feel better about paying taxes, even when it seems unfair:
Imagine that you have worked hard for a long time. You have gone to work, paid your bills, paid your taxes, taken care of your family, and so on. You have followed the “rules”, so to speak, and you are in pretty good shape. You are walking down your steps one day and do not see a patch of ice halfway down. You slip and fall the rest of the way down.
You miss a couple of weeks of work, but soon find out that you have injured yourself beyond repair. You will not be returning to work thanks to an injury you have just sustained to your back. Sure, your insurance may cover most of your hospital bills, but what about your rent or mortgage? What about your power bill and car payment? Even worse, how will you feed your kids from now on? Suddenly, you are faced applying for that same welfare you have complained about paying for.
You may be thinking, “That’s an exception.” Maybe, but how do you know? Can you really say with any amount of certainty that at least 75% of the people on welfare really do not need it? No, we cannot say that because we do not live with them. The point is that it is safest not to judge or make assumptions.
Now, let’s talk about a few things that taxes go towards
Defense
In other words, keeping our country safe. This goes to men and women who are willing to risk their lives to protect the rest of us as well as technology and other things they need to assist in this task.
Social Security
While social security is not the most amazing thing ever, a lot of elderly people do rely on it. And anyway, they paid into it. What you pay in will- ideally- be available to you when you need it.
Major Health Programs
Here we are talking about Medicare, Medicaid, CHIP, and the marketplace options. Most of this goes to children, the disabled and the elderly.
“Safety Net Programs”
These are at the discretion of the federal government.
Interest on Debt
This should be pretty self-explanatory.
Everything Else
This breaks down into: education, science and medical research, transportation, benefits for vets and federal retirees and a few other possibilities
The percentages often change to some extent, but those are the categories taxes are paid into. In short, your tax dollars go to: defending the country, caring for the defenseless such as the elderly, disabled, and little ones that cannot care for themselves, getting the country out of debt, education and so on.
Even when it seems unfair, understand that your money really is doing good for yourself and others, so paying taxes is really not so bad. Having said that, it is time to get an understanding of capital gains and what they mean for you and your taxes.
Is There a Way to Decrease What I Will Owe?
Ok, here are some of the most important things you should know before we move on:
Uncle Sam Will Get His Cut
Trying to completely avoid paying taxes is not a good idea, like at all. Even if the IRS does not catch onto tax evasion for a while, they will eventually.
Now, all that being said, there are ways to decrease the amount you owe while being completely legal about it. The following ways apply to capital gains tax as well as regular taxes:
Educate Yourself
The sad thing is many people lose out on money due to a lack of education on a subject. Years ago, I had a friend who worked for a tax agency. At the time I was a single mom, and I was complaining to my friend about my financial struggles. I had just finished filing my taxes, so he asked me a few questions about how that I had gone. When I told him, he asked me if I minded him looking at my paperwork.
I let him take a look, and he spotted quite a few exemptions that my tax preparer had missed. I had no clue I was even eligible for these things, but he amended my taxes and I ended up with more than I was told I would. Understand this: I had my taxes prepared by a professional who should have known these things, but she did not. Had I been aware of these exemptions, I could have asked questions and had it done right the first time.
You do not have to become a CPA or go to work for the IRS to know what you need to. Do exactly what you are doing now: research. Google can help you find legitimate websites that will give you the information you need. And the IRS has a website which you can learn from.
You can also take a trip to your local library for a tax guide or reach out to a place like H&R Block. By learning what does and does not apply to you, you can avoid paying for things you should not and get money back you did not even know you could.
Hang Onto Your Investments
As I stated earlier, when you hang onto investments for more than a year, you qualify for a long-term capital gains tax, which is lower. Unless you are in really desperate need, hang onto your investments for at least one year.
Give Them as Gifts
Instead of selling investments, many people are taking advantage of giving them to family. That is because giving them to members over 24 in lower tax brackets can lower the tax rate all the way to 0%. Many people are using their investments to help their kids and grandkids pay for college or even a new home.
Give to Charity
Here’s another awesome idea. Instead of giving cash, you can give your appreciated stock to charity. Not only do you avoid a capital gains tax but you can also get a tax deduction. In short, you help others (of your choosing) while saving money- can it get any better?
Keep Your Receipts
Always, always, always keep receipts of anything that you can deduct. This includes, of course, business expenses and similar items. However, it also includes improvements to investment properties. If you invest in a property then invest in fixing it up, like replacing a roof or plumbing, those receipts can help offset your profit. And do not forget that if you make investments into items that use lower energy, you can get an even bigger deduction.
Invest in Retirement or a 529 for College
If you invest in an IRA or a college savings plan, you can get a tax deduction- while saving for important things.
Pay Your Taxes on Time
Seriously, pay them on time. If you have to pay out taxes, pay them ASAP. If you do not, your amount will grow…and grow…and grow…and keep growing until you pay it. I know from experience. About six years ago, I made a mistake. I forgot to file my state taxes. I was pregnant with my fourth baby, two months from graduating from college, and taking care of a family of five- in addition to homeschooling. I had every intention of filing but went into labor earlier than expected and my life was turned upside for a short time.
Honestly, filing those taxes completely slipped my mind until the following year when I found out we were going to have to pay a fine for not filing. I kind of thought that was silly because, well, we always got a tax check back. Wasn’t the government saving a few hundred bucks by me not filing?
If You Pay Later, the Interest Is Higher
I guess they did not see it that way. Unfortunately, I could not pay the whole fine at once but paid ¾ of it and was planning on paying the remainder soon. Next thing I know, I am getting a bill that was almost the original amount. In the months I was not able to pay anything on the bill, we had been charged a ton of interest. The amount kept growing and, in truth, we literally just finished paying it off last year.
So, again, be sure that you pay your balance as soon as you possibly can. If for some reason you do not have all of that cash at once, try two things. First, call the IRS. See if you can work out some type of payment plan that will not result in hundreds or thousands of interest.
If that plan does not work, get a loan to pay it off now- but not just any loan. The loan needs to be a lower interest rate than what the IRS will charge. Look for a personal installment loan, or even a credit card with a low interest rate or 0% interest introductory period. I can almost promise you that either of those will be preferable to owing the IRS for years to come. These are the people that have the right and the ability to garnish wages. Do not risk it.
Conclusion
If you have sold or are considering selling any investments, educate yourself as much as you can on long-term capital gains tax. Read this article from beginning to end again and make sure you understand these basics. If you do not, make a plan to meet with a professional. Use this article as a starting point to write down any questions you may still have. Make a list to take with you so that you find out all you need to know.
Once you have a list, you may consider Googling those questions, as well. You might find the answers you need online, or it may at least give you additional questions to ask. The most important thing to remember here is that knowledge is, in fact, power, and knowing everything you can about the long-term capital gains tax can help you make sure you only pay what is actually required.
If you find yourself in need of a loan to pay your balance, as previously discussed, you should be strategic about it. First off, do not just go to any lender. Be sure that they are a reputable ones. Second, be sure that you know the terms and conditions of the loan and do your calculations. Which will cost you more: owing to the IRS or owing that loan? If the loan will cost more, turn that one down and find another. The idea here is to improve your situation, not put you into more debt.