What is the capital gains tax, and how can I calculate mine? — Elyse, New Jersey
We all know that the IRS wants a piece of everything we earn, whether it’s our salary or investments. Generally, the capital gains tax is a percentage owed to the government on the sale of assets that have increased in value since purchase, such as stocks, mutual funds, real estate or collectibles.
Here’s a simple example: Let’s say you purchase 100 shares of stock XYZ one year for $5,000 and then sell those shares a year later for $6,000. Your capital gain would be $1,000, which is the amount that would then be subject to capital gains tax. In most cases, the IRS can only tax you on capital gains that you’ve sold and received as income (aka “realized gains”). If you still owned those shares of XYZ, you would have what is known as an “unrealized gain” that is not subject to tax.
However, there are a few caveats. Some types of investment income can still be subject to capital gains tax even if the investment has not been sold, including qualified dividends received from stock, mutual funds and real estate investment trusts (REITs).
In regard to real estate, different tax rates apply to sales of personal and business property. Thanks to the Taxpayer Relief Act of 1997, though, there are some significant tax breaks when you sell your primary residence. According to the Act, if you've sold property that was your primary residence for at least two out of the last five years, you can exclude up to $500,000 in capital gains from the sale. Keep in mind, though, that the $500,000 exclusion is only available for married couples who file jointly. Individual filers can exclude up to $250,000 in gains. This means you don't have to pay taxes on money made from selling a primary residence unless the earnings exceed $250,000 or $500,000, depending on your filing status.
The easiest way to minimize capital gains tax is to avoid short-term investments. Long-term investments (e.g. those held for more than one year) will almost always have a lower tax rate than short-term investments. Another strategy is to shelter gains in tax-deferred retirement accounts like 401(k)s and IRAs, in which you can buy, sell and exchange securities without being subject to any capital gains taxes. You can also deduct capital losses on depreciated assets from your capital gains to lower your total taxable earnings.