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Category: Tax Tips

What Do I Need to Know About Capital Gains Tax?

Okay, first thing's first: capital gains are a good thing. If you have capital gains to consider as part of your tax picture, it means you made money on your assets. Something you sold was worth more than when you purchased it, leaving you with a profit in the end. This is great news—but Uncle Sam is going to want to know about it.

This is where the capital gains tax comes into the picture. As you might expect, your capital gains are going to be taxed, much like any other income you may earn throughout the year. Capital gains are not treated the same as something like wages, however, so it is important that you understand how the tax code applies to this money.

 

To provide you with some insight on the capital gains tax and how it may affect your tax situation in the coming year, we have outlined five important points below.

 

1. A Sale for a Profit - At the heart of the matter, capital gains are about selling something for a profit. It doesn’t necessarily matter what that "something" is (more on that later) as long as you have made money on the exchange. While some taxpayers tend to think of capital gains taxes as an issue that only relates to the rich, that simply isn’t the case. If you make a profit on the sale of an item, there is a good chance that profit will be subject to capital gains tax.

It is important to remember that you can include all of the costs of the item when determining whether or not you have made a profit. The initial cost of acquisition is the starting point, but there are likely to be other costs included as well.

*For example, did you spend money to repair or improve the item in some way? Those costs are included in your total investment. You will only need to worry about capital gains when your return is greater than the total investment you have made.

 

2. Extra Tax for Quick Sales - If you hold an asset for less than one year before turning around to sell it for a profit, you will likely need to pay a higher tax rate on your profits. Any profit that is made from an item which you owned for less than one year is considered a short-term gain. These short-term gains are subject to a higher tax rate than long-term gains, which are those assets you have owned for at least one year.

While this difference might not be enough to make you hold your assets for a long period of time, it is something to think about. For instance, if you can sell an asset at 13 months for the same profit you could sell it at 11 months, waiting the extra few weeks would serve to reduce your tax bill. The benefit here will depend on your tax bracket, however, so research your situation specifically before making any decisions.

 

3. We Aren’t Talking About Business - The capital gains tax is designed to capture taxes on the profits earned through the sale of personal possessions and investments. That does not include business profits, which are reported separately. Even if your business is only a part-time hobby rather than a full-time occupation, the earnings you receive in this manner are going to be seen as business profits. It is important to keep these separate from capital gains, as they are taxed under a different rate (and reported differently on your return).

For some people, the difference between business and personal profits can be a bit blurry. For example, imagine that you like to collect old cars, and you usually sell them after spending time rebuilding the engines or restoring the interiors. If you do this just once in a year, that is probably not enough to call it a business, and your profits (if there are any) will be considered capital gains.

On the other hand, if you turn over several vehicles per year, and plan to report the expenses you incur as business expenses, the profits from this operation will likely be classified as business income. As a general rule of thumb, if you plan to make a profit and you run the operation in a "businesslike" manner, it is going to be considered a business in the eyes of the tax laws.

 

4. Your Home Doesn’t Count. Probably. - If you are like most people, the biggest asset you own is your home. With any luck, you will have significant equity in that home when you are ready to sell, and you may be counting on the profits from that sale to provide you with a down payment for your next house. But what about capital gains on property? Do you have to pay a significant amount of tax when you profit from the sale of your house?

Fortunately, the answer is no for most people. As long as you meet a few basic criteria, you will be able to exclude most or all of the financial gain from the sale of your home. For starters, you need to have owned your home, and used it as your primary residence, for at least two of the five years prior to the sale. Also, you cannot have used a tax exclusion on the sale of another home in the previous two years leading up to the sale.

Assuming those conditions do not apply to you, you will be able to exclude a significant amount of profit when you sell your house. For a single homeowner, the exclusion is $250,000, and it doubles to $500,000 if you are married (and filing a joint return). Unless you have surpassed those lofty numbers, you are not going to be responsible for capital gains taxes stemming from the sale of your home.

 

5. Remember the Losses - You might not want to think about your losses as much as your gains, but any capital gains loss you experienced throughout the year can be used to offset your gains from a tax perspective. However, this benefit does not apply when talking about property, such as the classic cars we mentioned earlier.

With regard to losses, only losses stemming from investments will be eligible to reduce your capital gains total. If you are an active investor, it is likely that you will have a mixed bag of gains and losses in any given year. Be sure to account for all of those investments on your taxes so you can be treated fairly under the capital gains rules.

Accurate record keeping is essential when it comes to capital gains. You need to have documentation for when you made purchases, when sales become official, and any other relevant details. Make sure you keep receipts for expenses you incurred in the process of ownership, as those will help you to reduce the amount of profit which is exposed to the gains tax.

You might not be able to get away from paying these kinds of taxes, but you can take steps to reduce your bill by properly keeping records and only paying on the true profit of each sale.