Explaining Capital Gains and Tax Rates

calculating capital gains with charts

During a very tough 2020 year for many, it seems that the values of properties have skyrocketed in many forms. Property is not just relating to real estate or real property. The IRS considers property anything owned by a person or entity. 

Property is divided into two types: real property is any interest in land, real estate, growing plants or the improvement on it, and personal property which is everything else. We have seen a boom in the real estate market since there is a high demand to buy properties with a lot fewer sellers. Also, it has been a good year for stocks and an especially good year for cryptocurrency. These are all considered property and may result in some painful capital gains tax bills. 

This article will discuss what capital gains are, how they are determined, how they are categorized, and how they are taxed. It is especially important that you understand these taxes whenever you sell an asset or property. By learning this basic knowledge, you will be able to better tax plan so at the end of the year you are prepared to report that income correctly.

 

What Are Capital Gains?

A capital gain is what tax laws call the profit you receive when you sell a capital asset, which is property such as stocks, bonds, mutual fund shares, and real estate. Capital gains are categorized into two different categories: short-term capital gains or long-term capital gains. The difference between these two is determined by the holding period of the asset or property. 

Short-term gains and losses are those realized from the sale of property or assets that you have held for 1 year or less. 

Long-term capital gains and losses are realized after selling investments held longer than one year.

 

Capital Gains Tax Rates

Short-term capital gains are taxed as though they are ordinary income. If you hold an asset or property for less, than one year any gains or losses will be treated as short-term gains or short-term losses. They are taxed at your maximum tax rate just like your wages or salary income. The top federal tax rate is 37%If you show a loss you can deduct up to $3000 from your regular income each year and you are also allowed to carry this over the next years if more than $3000.

Long-term capital gains are realized after selling assets or property held longer than 1 year. For long-term capital gains, the capital gains rate applies and it is typically significantly lower than your normal income tax rate. The capital gains rate is anywhere from 0-20%. 

The exact rate at which your gain is taxed is based on the amount of your income. For single tax filers, for anybody with income below $40,400 the capital gains rate would be zero. For anybody who makes incomes between $40401 and $445,850 the 15% capital gains rate would apply. Single filers with income above $445,850 will get hit with the 20% tax rate. For married filing jointly any couple with income of $80,000 or less the capital gain rate would be zero Any married couple with income of $80,000 and 501,600 will have the capital gains rate of 15%. Married couples with incomes above $501,600 will get hit with the 20% long-term capital gains rate. This is shown below on a chart by Fidelity. 

 

Long-term capital gains rate by filing status and income: 2020

Long-term capital gains tax rateSingle tax filersMarried filing jointly
0%$40,000 or less$80,000 or less
15%$40,001 – $441,450$80,001 – $496,600
20%$441,451 or more$496,601 or more

 

 

How Do I Figure Out My Gains and Losses?

This is especially important. When a property is sold, you do not have to pay taxes on all money received. You only must pay taxes on your gain or profit. To determine what your gain on the transaction is you must first determine your cost basis. This is the price you paid to purchase a property or asset. This can also include additional fees such as closing costs, broker fees, or commissions. There are two methods to calculate your cost basis.

Average Cost Method

This method takes the total cost of the shares and divides it by the number of shares in the fund. We use this method to calculate the cost basis for mutual funds and certain dividend reinvestment plans.

Actual Cost Method

With this method, your cost basis is the purchase of each share.

With real- estate the cost basis can be adjusted over time. The cost basis on real estate can be the initial purchase price and then you can increase the cost basis over time with the cost of improvements to the property. This is where it is important to know how to define the difference between a repair and an improvement.

 A general rule of thumb to differentiate is that an improvement would raise the value of the home such as a pool or addition. Repairs are general costs incurred to maintain your property. Repairs are not added to the cost basis but if this is a rental property they can be written off as an expense. So, keep track of all those home improvements or remodeling projects that you spent money on to improve your home because these can raise your cost basis.

A capital gain or capital loss is figured by subtracting this cost basis from the actual sale price plus costs. This will determine the gain or the profit or the loss. If you have multiple gains and losses, then you must do some further math. This is where it can get a little confusing. 

If you have all long-term gains or losses, you just add the gains together and subtract the losses. The result of this combined number will become your long-term gain and will be taxed by the long-term tax rate. The same thing will be done if you have all short-term gains. If you have gains from both long-term and short-term, they will stay separate, and each amount taxed by their own rules.

 If you have losses of both short-term and long-term, then they will stay separate and can be deducted up to $3000 from regular income. If the losses are greater than $3000, they can be carried over in the next years. If you have a combination of short-term losses and long-term losses, you will combine these, and the result will be based on the tax rule of the greater amount. 

With mutual funds, these rules do not apply. Gains from mutual funds are taxed as regular income and can not be offset with short-term losses.

When it comes to real estate transactions there are additional rules, and you may be able to avoid paying a substantial amount of taxes on your gains. If the property was your primary residence and you have lived in the property for at least two of the past five years, then you may be able to exclude up to $250,000 in capital gains if single and up to $500,000 if married.  

So if somebody purchases a property in 2013 for a total of $300,000 with costs included in that number then the $300,000 would be their cost basis. This has been their primary residence during the whole time they owed the property. In 2020 they sold this property for $600,000 and they are filing single that tax year then they would only be reporting a gain of $50,000.  

The math below demonstrates how you come to the actual gain on the property.

$600,000 (Sale price of property) – $300,000 (cost basis) = $300,000 – $250,000 (exclusion for primary residence) = $50,000 taxable long-term gain.

In conclusion, taxpayers have a long-standing responsibility to report gains and losses and related cost basis information when they file their income tax returns. Brokers also have a requirement to report all sales information to the IRS on Form 1099-B. 

To report capital gains on your return you must file a Schedule D with your Form 1040. Most filers need to begin with Form 8949 which provides the format for listing each individual sales transaction.  If you have multiple transactions this can become especially complex. I would highly recommend that with a return of this nature that you hire a true licensed tax professional. An Enrolled Agent or CPA is somebody who has the licensing showing that they have the required education and knowledge to help in a situation like this. 

Any errors in the reporting of the income can be caught by the IRS and they will charge you significant penalties and fees so the tax professional is well worth the money spent to make sure it is done correctly.  

Also, I cannot reiterate enough the importance of tax planning and keeping records throughout the year to make sure nothing it s missed that can either save you money to reduce taxable income or make sure you don’t set yourself up for an audit or examination by missing something.

 

Ozzie Gomez is a Senior Tax Settlement Agent and the owner of Innovative Tax Relief which holds business licenses in Tax Resolution, Tax Audit Representation and Tax Preparation.  With almost 10 years of experience in the tax resolution industry, he has personally helped more than 4,000 individuals and businesses resolve their tax issues.

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