How to Calculate Capital Gains Tax

The hard thing about calculating your capital gains tax isn’t what rate to use (and there are several) but how to figure out how much capital gain you actually have.  It’s a pesky little thing called cost basis that complicates everything so we’ll try and break it down for you.  First, a general idea of how it all works.

Calculating Capital Gains Tax

Once you know how much you’ve profited, the rest is simple.  You must only figure out whether it’s short-term gain or long-term gain, and then apply the appropriate capital gains tax rate, explained here.

As we mentioned in that post, short term gains are taxed as if they were regular income, so the tax on that profit is whatever tax bracket you’re in.  For long-term gains, it’s probably a lower rate, either 0%, 15% or 30%.

What is the Cost Basis?

To figure out how much you actually profited when you sold your shares or other property, you have to figure out how much you actually paid for it.

Let’s say you inherited the investment, then you want to sell it.  You didn’t pay a dime for it, so what is your cost basis?  Simple: take the value of the investment on the day the original owner passed away.  That’s the cost basis, which you will subtract from the selling price to arrive at your profit.

The cost basis is simply the price you paid for your stock, if that’s the capital you’re selling (if we’re talking real estate well same thing: cost basis is the price you paid for the property).

The Slippery, Sliding Cost Basis of Stock

What complicates stock sales is that over time you may have purchased more shares at different prices.  Now, it used to be that it was up to you to keep track of your own cost basis.

Not anymore…sort of.  Since 2011, brokers are required to keep track of more of this for you.  But you still have to keep your own records, even if you just keep track of when you purchased, then look up the stock price for that day on any financial website.  Moral of the story: keep those statements your brokerage sends you: you’ll need then at tax time for figuring stock basis, the year you sell.

How to Simplify Things

Reinvesting dividends of course is a nightmare when you want to figure cost basis.  Sometimes it’s worth it to just accept a cost basis of zero since the difference is so small.

If you have a mutual fund, you can average everything for simplicity’s sake.

5 Things to Know About Capital Gains Tax on Shares

If you’ve earned a profit from selling shares, then here are four things you should know about the capital gains tax on shares.  Making a profit in the stock market is always a great thing, but you don’t want to mitigate your joy by paying more capital gains taxes than you have to.  Here are five  things you should know about capital gains taxes on shares:

1.  Long-Term Capital Gains Have Lower Tax Rates

Hold onto your shares for at least a year before selling, and you’ll save on taxes.  That’s because once you’ve held the shares for more than a year, they go from being short-term to long-term holdings.  When you sell a long-term holding you get a long term capital gain…which is taxed at one the following rates:

  • 0% (we like this one! its’ for taxpayers in the two lowest tax brackets)
  • 15% (for those in higher tax brackets)
  • 20% (for wealthy taxpayers)

2.  And Vice Versa: Short-Term Capital Gains Have Higher Tax Rates

Sell your share too soon and the profit will be treated as regular income.  That means you pay income tax at the rate of your regular income and won’t get to take advantage of the lower, special rates that accompany long-term capital gains on shares.

Again, try and keep your shares for at least one year before selling, to take advantage of lower tax rates.

3.  You Don’t Owe Capital Gains Tax Until You Actually Sell!

That means you have control…you decide whether you want to keep your shares for longer than a year for lower tax rates, or whether you want to sell more quickly to take advantage of a market situation.  The point here is: you have control over your financial destiny here.

4.  The Only Way Out of Capital Gains Tax on Shares is Death

If you die before you sell your shares, your heirs won’t have to pay any capital gains tax at all!  This is something to think about if you are at a stage in life where you’re thinking about estate planning.

5.  Use Losses to Offset Gains

If you sell some shares and make a good profit, see what you can dump at a loss to offset the taxes.  If you own “dead” shares that are never going anywhere, now’s the time to sell them, even if it’s at a loss.  At least that loss will help you out with your taxes by reducing the amount of profit you make overall, meaning you’ll pay less capital gains taxes.

What’s the Capital Gains Tax on Real Estate?

Capital gains taxes are subject to a little bit of control by you, the taxpayer.  What does that mean?  It means you have some say in what rate you’ll end up paying when you make a profit on selling your capital assets.

Timing is Everything

As we learned in How to Get the Most Favorable Capital Gains Tax Ratethe timing of your sale is everything.  For normal capital gains like the sale of stocks, all you have to do is hold the stock (or whatever capital it may be) for more than one year and you will pay a lower tax rate because the tax on long-term capital gains is lower than on short-term gains.

Some Capital Gain on Real Estate is Excluded Altogether

Well it’s the same with real estate.  If you keep your home (and live in it)  for more than two years then you get to exclude $250,000 of your profit from taxes altogether.  Actually the rule is a little more complex: you must have owned and lived in the house for at least 2 of the five years preceding the sale.  Make sense?  This is called the Ownership and Use Test.

Married couples can combine their exclusions and exclude $500,000 from taxes.  Nice!

How to Calculate Your Exclusion

It’s not simply a matter of subtracting the purchase price from the sale price.  You get to adjust the figures a bit, and usually this helps you.  Here’s the basic formula:

selling price – deductible closing costs – selling costs –  depreciation – insurance payments –  (original purchase price + purchase expenses + improvement costs)

All those adjustments usually work out to your favor so keep records of everything you do concerning owning your home.  You’ll need them when you file your taxes the year you sell the property.

What About a Second Home?

You can exclude capital gains on the sale of a second home, but not to the same degree, and with some rules.  If you sometimes used the vacation home as your primary residence, then you can pro-rate the exclusion on your tax return when you sell.  If you merely used the property as a rental and never lived in it yourself, then you won’t be able to take advantage of any capital gains exclusions when you sell.  You’ll be paying capital gains tax on the full sale price.

Avoid Paying Tax on Big Gains

If you split up the ownership of your home before you sell it, then each owner can use his or her $250,000 towards one pooled exclusion.  A couple can “sell” part ownership of their home to an adult child.

Then when the property is sold there are then three instead of two people to each pool $250,000 into the exclusion.  Now, when this home sells a total of $750,000 will be excluded from capital gain tax.

How to Get the Most Favorable Capital Gains Tax Rate

You have only yourself to blame if you feel that you’re paying too high a tax rate for capital gains.  Why?  Because there are actually two different rates you can choose from, depending on how long you held the capital before selling.   And of course you make the decision as to when you want to sell your own “stuff.”

In the case of the capital gains tax rate, “stuff” usually means stocks.  But of course it can mean almost anything from your home to anything else you make a profit from when you sell it.

How to Pay the Highest Tax Rate on Your Capital Gains

If you don’t own the item being sold very long, you’ll pay a higher rate when you sell.  In the case of capital gains, they’re considered “short-term” when you own them for less than one year before selling.

If you make a profit, your capital gains tax rate will be the same as your ordinary tax rate.  That can range from 10% to almost 40% (39.6%) for the most recent tax year (2014) for which the rates have been announced.

Below, you’ll see a more desirable array of tax rates at which your capital gains could be taxed, and the difference is all in the timing…

Favorable Capital Gains Tax Rates

When you hold something for more than a year, it’s then considered a long term asset.  Therefore, when you sell it, the profit you make (if you make a profit) you’ll have what’s called a long term capital gain.

That matters because it affects the tax rate you’ll pay the IRS on that income.  Currently, the long term capital gains tax rates are:

  • 0%
  • 15%
  • 20%

The rate you pay depends on your ordinary tax rate.  However, as you can see, the most you’ll pay for long-term gains is 20%, whereas for short term gains it’s 39.5%, which is almost double, shockingly.

Beating the System

This is why we pay money managers to take care of our wealth…so we don’t inadvertently make a mistake and end up paying short term capital gains tax rates on something which could have easily been turned into a long term capital gain simply by waiting a bit more time!

What You Might Not Know About the Capital Gains Tax

Think the Capital Gains Tax is just for savvy investors?  Think again.  If you sold anything at all in the past year, you may be subject to income tax on that sale.  Just goes to prove again and again: the IRS is in the business of getting money!

The Capital Gains Tax: Not Just for Wall Street Types

Capital means property.  Property doesn’t mean only real estate.  It means your blender, your bank account, your boat, your  car.   When you sell your property for a profit, you are creating what’s called Capital Gains.  That’s income and guess what that means…the IRS gets involved.

Capital Gains = Income from Selling Your Stuff (property)

So now you see that capital gains isn’t just for wall street types, although they’re usually the ones who are worried about it.  Capital gains is any profit you make from selling your things.  It’s just that successful wall street types make a lot of money from selling their things because their “things” happen to be stocks.  There is a lot of money to be made in stocks, which amounts to a lot of capital gains.  No wonder they’re worried about the Capital Gains Tax!

OK So I have Capital Gains…What Do I Do Now?

When you file your income tax return, you’ll have to use IRS Form 1040.  The Capital Gains Tax form cannot be attached to the 1040EZ or the 1040A.  It’s the big-time for you now, so to go along with it, you need the long form 1040.

You’ll be reporting your Capital Gains Tax on Schedule D, called Capital Gains & Losses.  You’ll also be reporting your Capital Gains on IRS Form 8949, Sales & Other Dispositions of Capital Assets.

One more thing to know: there are two types of Capital gains.  The Capital Gains Tax is different depending what type you have.  Here’s the difference:

  1. long term capital gains: you owned the property for more than a year before selling
  2. short term capital gains: you owned the property for less than a year before you sold it

Short term capital gains are taxed just like regular income…at whatever tax bracket you are already in.  That can mean a higher tax rate  since the Capital Gains Tax for long term assets is 15% for the most part.

How to Learn More

You can read about the Capital Gains Tax by downloading IRS Publication 550.  It’s the IRS guide to how they treat investment income.  There’s also IRS Publication 544 which tells all about what happens, tax-wise, when you sell your home. Both are available on the IRS website.  Just type in the publication numbers into their search box, or use a search engine.