When you hear the term “capital gains tax,” you may think it’s something only wealthy investors need to worry about. But any capital asset that is sold for a profit can be subject to capital gains tax.
If you’re a beginner investor or are planning to sell a house, you should definitely know how capital gains work.
But just what is capital gains tax? Read on to understand some of the basic terms around this topic.
WHAT IS A CAPITAL ASSET?
A capital asset is property you own for investment or personal purposes. This can include anything from stocks and bonds to houses and cars. When you sell a capital asset, you earn a capital gain or incur a capital loss, generally depending on how much you bought it (i.e., the property’s cost basis) and subsequently sold it for.
WHAT IS A CAPITAL GAIN VS. A CAPITAL LOSS?
A capital gain is the profit you make by selling an investment (such as stocks or bonds), real estate or personal property. To calculate a capital gain, subtract the cost basis of the investment from its final sale price. If the resulting number is positive, then you have realized a gain, and you must pay taxes on that profit. If the resulting number is negative, then you have realized a capital loss, which is not taxed; in fact, a capital loss can offset your other capital gains and up to $3,000 of ordinary income and reduce your tax liabilities for the year of the loss.
WHAT ARE REALIZED VS. UNREALIZED GAINS?
If you buy an investment and the value of that investment increases — but you’re still holding onto it — then you have “unrealized” gains. In other words, your gains aren’t “realized” until you actually sell your investment and convert those profits into cash. Unrealized gains are not taxed, but realized gains are.
Any capital asset that is sold for a profit can be subject to capital gains tax.
WHAT IS CAPITAL GAINS TAX?
A capital gains tax is the tax you must pay on any realized gain that results from selling your capital assets. Capital gains come in two main varieties, short-term and long-term, which are defined by how long you held the investment prior to selling it for a profit. Short-term capital gains are typically taxed at a higher rate than those realized in the long term. That’s because the government is trying to encourage investors to hold onto their investments for longer periods of time, as short-term buying and selling can have a destabilizing effect on the market.
WHAT COUNTS AS A SHORT-TERM CAPITAL GAIN?
A short-term capital gain is any profit that you realize from an investment that you have held for one year or less. For example, if you buy shares in a company and sell them for a profit within one year of the purchase date, you will be required to pay the short-term capital gains tax rate on that profit. Short-term capital gains are taxed at ordinary income tax rates (that is, the rate you pay based on which federal income tax bracket you fall into). For the 2019 tax year, this ranges from a low of 10 percent to a high of 37 percent.
WHAT COUNTS AS A LONG-TERM CAPITAL GAIN?
A long-term capital gain is any profit that you realize from an investment that is held for more than one year. Say you purchase shares in a company and hold them for 10 years. If you sell them for a profit, you will pay the long-term capital gains tax rate on that income. Currently, long-term capital gains are taxed at a lower rate than short-term gains.
The long-term capital gains tax rate that you will be charged on the money you make by selling an investment will mainly depend on your income level and your filing status (e.g., single filer, married couple filing jointly, head of household, etc.). You will likely need to include a Schedule D (Form 1040) as part of your tax return.
WHEN DOES THE CAPITAL GAINS TAX APPLY?
Still not sure whether you need to worry about paying capital gains taxes? Here are some quick guidelines:
If your only investments are in the form of contributions you are making to a retirement account like a 401(k), 403(b) or IRA, then you don’t need to worry about the capital gains tax. These tax-advantaged accounts allow your investments to grow tax-deferred until you use them in retirement, at which point any disbursements will be taxed at your ordinary tax rate. And you generally will not be required to pay taxes on distributions from a Roth 401(k) or Roth IRA, as your contributions to those accounts were taxed before you put them in.
If you have made investments outside of a retirement account, be aware of their tax implications. Understand the difference between short- and long-term capital gains and plan the sale of those investments accordingly. You may be able to use some of your investment losses to offset your gains in a strategy known as tax-loss harvesting, but you should consult a tax advisor to see if it makes sense for you.
- If you are considering selling something (an investment or valuable piece of property) to realize a capital gain, it’s important to understand how this action could affect your tax situation. Again, consult a tax advisor to make sure this makes sense for your personal financial situation.
This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.