A capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment.
Definitions and Rates
Capital assets generally include everything owned and used for personal purposes, pleasure, or investment, including stocks, bonds, homes, cars, jewelry, and art. The purchase price of a capital asset is typically referred to as the asset’s basis. When the asset is sold at a price higher than its basis, it results in a capital gain; when the asset is sold for less than its basis, it results in a capital loss. Although capital gains taxes typically apply to the returns from any capital asset, including housing, U.S. homeowners benefit from a generous exemption for gains resulting from the sale of their primary residence, set at $250,000 for single filers ($500,000 for joint filers).
In the United States, when a person realizes a capital gain, they face a tax on that gain. The tax rates vary depending on two factors: how long the asset was held and the amount of income the taxpayer earns. If an asset was held for less than one year and then sold for a profit, it is classified as a short-term capital gain and taxed as ordinary income. If an asset was held for more than one year and then sold for a profit, it is classified as a long-term capital gain. Table 1 indicates the tax rates for tax year 2024.
2024 Long-Term Capital Gains Tax Brackets
| For Unmarried Individuals, Taxable Income Over | For Married Individuals Filing Joint Returns, Taxable Income Over | For Heads of Households, Taxable Income Over |
|---|
| 0% | $0 | $0 | $0 |
| 15% | $47,025 | $94,050 | $63,000 |
| 20% | $518,900 | $583,750 | $551,350 |
Source: Internal Revenue Service, “Revenue Procedure 2023-34.”
Is Capital Income Tax-Advantaged?
The tax treatment of capital income, such as from capital gains, is often viewed as tax-advantaged. In practice, however, the opposite is true. When capital gains accrue from stock holdings, they represent a second layer of tax, as corporate earnings are already subject to corporate income taxes.
The Impact of a Capital Gains Tax
Capital gains taxes affect more than just shareholders; there are repercussions across the entire economy. When multiple layers of tax apply to the same dollar, reducing the after-tax return to saving, taxpayers are incentivized to consume immediately rather than save. Take the following example from our primer:
Suppose a person makes $1,000 and pays individual income taxes on that income. The person now faces a choice: should I save my after-tax money or should I spend it? Spending it today on a good or service would likely result in paying some state or local sales tax. However, saving it would mean paying an additional layer of tax, such as the capital gains tax, plus the sales tax when the money is eventually used to purchase a good or service. This second layer of tax reduces the potential return that a saver can earn on their savings, thus skewing the decision toward immediate consumption rather than saving. By immediately spending the money, the second layer of tax can be avoided.
The Lock-in or Realization Effect
Because capital gains are only taxed when realized, taxpayers can choose when they pay, which makes capital income significantly more responsive to tax changes than other types of income. Higher taxes cause investors to sell their assets less frequently, which leads to less taxes being assessed. This is known as the realization or lock-in effect, which is demonstrated in the chart below.
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FAQs
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
How much tax will I pay on capital gains? ›
Holding onto an asset for more than a year before selling generally results in a more favorable tax rate of 0% to 20%, whereas assets sold within a year or less of ownership are subject to regular income tax rates, ranging from 10% to 37%. Capital gains taxes apply to assets that are "realized," or sold.
What is capital gains tax in simple terms? ›
Capital gains tax is a tax on any profit you make from the sale of a capital asset, such as property or equities.
How much money qualifies for capital gains tax? ›
For the 2024 tax year, individual filers won't pay any capital gains tax if their total taxable income is $47,025 or less. The rate jumps to 15 percent on capital gains, if their income is $47,026 to $518,900. Above that income level the rate climbs to 20 percent.
At what age do you not pay capital gains? ›
Since there is no age exemption to capital gains taxes, it's crucial to understand the difference between short-term and long-term capital gains so you can manage your tax planning in retirement.
Do I have to buy another house to avoid capital gains? ›
Can You Avoid Capital Gains Tax On Real Estate? It's possible to legally defer or avoid paying capital gains tax when you sell a home. You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion.
Are capital gains added to your total income and put you in a higher tax bracket? ›
Long-term capital gains cannot push you into a higher income tax bracket. Only short-term capital gains can accomplish that because those gains are treated as ordinary income. So any short-term capital gains are added to your income for the year.
What is the 6 year rule for capital gains tax? ›
Here's how it works: Taxpayers can claim a full capital gains tax exemption for their principal place of residence (PPOR). They also can claim this exemption for up to six years if they move out of their PPOR and then rent it out. There are some qualifying conditions for leaving your principal place of residence.
Do capital gains count as income? ›
While capital gains may be taxed at a different rate, they're still included in your adjusted gross income (AGI) and can affect your tax bracket and your eligibility for some income-based investment opportunities.
Do senior citizens have to pay capital gains tax? ›
The IRS allows no specific tax exemptions for senior citizens, either when it comes to income or capital gains. The closest you can come is contributing to a Roth IRA or Roth 401(k) with after-tax dollars, allowing you to withdraw money without paying taxes.
While the federal long-term capital gains tax applies to all states, there are eight states that do not assess a long-term capital gains tax. They are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming.
What is an example of a capital gain? ›
The tax on capital gains only occurs when an asset is sold or “realized.” For example, if Bob buys ten shares of Stock X for $10 and then sells the ten shares for $15, Bob's capital gain is $50. There are two categories of capital gains: short-term and long-term.
How to avoid paying capital gains tax? ›
An easy and impactful way to reduce your capital gains taxes is to use tax-advantaged accounts. Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don't pay income or capital gains taxes at all on the assets in the account.
How do I calculate my capital gains tax? ›
How to Calculate Your Long-Term Capital Gains Tax
- Determine your basis. The basis is generally the purchase price plus any commissions or fees you paid. ...
- Determine your realized amount. ...
- Subtract the basis (what you paid) from the realized amount (what you sold it for) to determine the difference. ...
- Determine your tax.
If you have lived in a home as your primary residence for two out of the five years preceding the home's sale, the IRS lets you exempt $250,000 in profit, or $500,000 if married and filing jointly, from capital gains taxes.
Can I reinvest my capital gains to avoid taxes? ›
Do I Pay Capital Gains if I Reinvest the Proceeds From the Sale? While you'll still be obligated to pay capital gains after reinvesting proceeds from a sale, you can defer them. Reinvesting in a similar real estate investment property defers your earnings as well as your tax liabilities.
How can I reduce capital gains tax? ›
You could:
- Stagger the sale of assets over several tax years to make the most of using your CGT allowance over several years. ...
- Offset any losses you've made on other assets. ...
- Invest your assets in an ISA or pension – sheltering them from tax.
The limit on the exemption of Long-Term Capital Gains on the transfer of equity shares or equity-oriented units or units of Business Trust has increased from Rs.1 Lakh to Rs.1.25 lakh per year. However, the rate at which it is taxed has increased from 10% to 12.5%.
