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Saturday, March 02, 2024

Understanding long-term capital gains tax

Understanding long-term capital gains tax

04.21.2023

As an investor, it’s important to understand that any profits made on various investments, including stocks, bonds, and real estate, are typically subject to federal taxes. The IRS refers to this type of income as capital gains, and the amount of tax you owe depends on several factors, including how long you held the asset, your tax filing status, and your taxable income.  States have their own various rules around capital gains taxes, so we’ll just focus on federal rules here.

Before selling any significant assets, investors should know the impact of both short-term and long-term capital gains taxes, which can help you develop a strategy for minimizing your overall tax burden. This guide takes a closer look at long-term capital gains tax and how it can impact your tax liability.

What are long-term capital gains and losses?

A capital gain occurs anytime you make a profit selling a capital asset, such as real estate, stocks, bonds, precious metals, jewelry, or real estate. Alternatively, a capital loss is any time you lose money when selling a capital asset.

When you make a profit, you realize a taxable gain. However, the IRS doesn’t treat profits on capital assets the same. The amount of taxes you owe depends on what type of asset it is, your taxable income and tax bracket, and how long you owned the asset.

The first thing to understand is the difference between short-term and long-term capital gains.

Short-term capital gains are profits you earn on any asset you’ve owned for less than 1 year. Typically, these gains are added to your taxable income for the year. The amount of tax you owe is based on your marginal income bracket for that year, which is broken down into seven varying tax rates from 10% to 37% in 2023. Keep in mind that depending on your taxable income, the addition of short-term capital gains could also put you in a higher tax bracket.

Long-term capital gains, on the other hand, are profits you earn on assets you’ve held for more than one year. The IRS doesn’t tax these gains the same as your other taxable income. Instead, it looks at your taxable income for the year and your filing status to determine if your tax rate is 0%, 15%, or 20%. See the charts below to find out what the long-term capital gain tax rates are for 2023.

The IRS doesn’t treat all long-term capital gains the same. There are a few exceptions to the above rules, such as:

  • Sale of real estate: As long as you owned and have lived in a property as your primary residence for at least 2 out of the last 5 years, you may be eligible for a $250,000 exemption on any profits earned through the sale of your home. This means that you don’t have to pay any capital gains tax unless you make over $250,000 in profits. Even if your profits on the sale of your home do exceed $250,000, you only pay taxes on the portion over that amount.  Note that the $250,000 exemption is per person, so it would be $500,000 for married couples filing jointly.
  • Sale of collectibles: Earnings gained from the sale of collectibles held more than one year, such as fine art, jewelry, antiques, and precious metals, are long-term capital gains, but the IRS taxes these profits differently. In most cases, you can expect to pay a 28% long-term capital gains tax rate on any profits made when selling these assets, no matter what your tax filing status or taxable income is.
  • Net investment income tax: Depending on your net investment income in a given year, you may also be subject to an additional 3.8% net investment income tax.1 Net investment income can include dividends, interest, and capital gains, among many other sources. This extra tax is only for investors whose net investment income is over $250,000 if married filing jointly, $200,000 if married filing separately or head of household, or over $125,000 if filing single.

Examples of long-term capital gains

To better understand how long-term capital gains works, let’s look at a few examples:

  • Mary purchased stock in Company ABC 6 months ago for $500. She just sold the stock for a value of $750. Since Mary held this stock for less than 1 year, she must report it as a short-term capital gain. Therefore, she must include the $250 profit minus any applicable fees and commission as part of her taxable income and use her standard marginal income rate, based on her filing status and total taxable income.
  • Bob purchased $5,000 worth of stock in Company XYZ 10 years ago. He then sells this stock in 2022 for $30,000. Bob must pay long-term capital gains tax on the $25,000 profit minus any applicable fees and commissions. If Bob’s tax filing status is married filing jointly and his taxable income for the year is $400,000, the tax rate he must pay on these profits is 15%.
  • Sally purchased a home in 2000 for $450,000. She lived in this home continuously since 2000 until she sold it in 2022 for $650,000. Since Sally’s profit of $200,000 is under the $250,000 exemption, she will not owe any long-term capital gains tax on the sale of her home.

Advantage of long-term capital gains

Long-term capital gain tax is almost always lower and therefore more advantageous than short-term capital gain tax.

  • Jenny earns $40,000 in 2022 and files as a single taxpayer. During the year, she sold $3,000 worth of stock she bought for $2,000 in 2015. Based on her income and tax filing status, Jenny will incur a 0% long-term capital gains tax rate on her $1,000 profits. Jenny also sold $2,000 worth of stock that she purchased 6 months ago for $1,500. Since the IRS considers this a short-term capital gain, Jenny must include this in her taxable income, which will be taxed at 12% per 2022 tax brackets. Assuming Jenny’s income doesn’t go above $44,625 in 2023, she could have avoided paying a 12% tax on her $500 profit if she waited another 6 months to sell her stock.
  • John purchased $5,000 of stock 6 months ago, and he is ready to sell. He is a head of household and expects to earn $52,000 for the 2022 tax year. However, he just received a promotion that will increase his salary to $65,000 for the 2023 tax year. If John sells his stock in 2022 for $6,000, he will have to include the $1,000 short-term capital gains as income. Using the 2022 tax brackets, John will have to pay a 12% tax on this $1,000 profit. On the other hand, if John holds this stock and sells it for $6,000 in 2023, it will be considered a long-term capital gain. Since John's salary increases in 2023, he will move up to the next long-term capital gains tax bracket and pay 15% taxes on this $1,000 profit. In this scenario, it would be good for John to sell his stock now rather than hold it for a year.

The IRS allows taxpayers to combine their capital gains and losses. Deducting your long-term capital losses from your profits can help to minimize your overall tax burden. If your capital losses exceed your gains, you can reduce your taxable income by up to $3,000 per tax year. The IRS also allows you to carry over any additional losses to future years.

Long-term capital gains tax rates 2023

Prior to 2018, the capital gains income brackets closely resembled standard IRS tax brackets. However, the Tax Cut and Jobs Act of 20172 made them more favorable for investors. The IRS breaks these brackets down by filing status and bases them on three tax rates, including 0%, 15%, and 20%.

Below is a look at the capital gains tax rates for 2023.

Long-term capital gains tax rates for 2023

Tax filing status

0%

15%

20%

Single

$44,625 or under

$44,626 to $492,300

over $492,300

Married filing jointly

$89,250 or under

$89,251 to $553,850

over $553,850

Married filing separately

$44,625 or under

$44,626 to $276,900

over $276,900

Head of household

$59,750 or under

$59,751 to $523,050

over $523,050

Our take

In many cases, holding your investment for at least one year to take advantage of the lower long-term capital gains tax rates can lead to a lower tax bill. But taxes shouldn’t be the only consideration in deciding whether to buy or sell an asset. Knowing when to hold your assets and when to sell can be quite complex depending on the specifics of your individual situation. It’s always recommended to discuss your options with a financial professional, who can evaluate your specific situation and offer recommendations to help minimize your tax liability.

RO2812797-0323

1 IRS, “Topic No. 559 Net Investment Income Tax.”

2 Congress.gov, “H.R.1 - An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”

JJ Lester, CFP®

Contributor

JJ Lester is a CERTIFIED FINANCIAL PLANNER™ professional at Empower. Prior to his work at Empower, JJ served both as an estate specialist at Oppenheimer Funds and financial advisor through LPL Financial. JJ holds an M.S. in Management from The American College of Financial Services and a B.A. in Psychology from the University of Colorado, Boulder.

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