Guide to Capital Gains Taxes

When you sell any type of asset—including stocks, bonds or even your home—any profit you earn may be subject to taxes. This levy is known as capital gains tax.

Tax avoidance shouldn't drive your investment strategy. However, having a solid understanding of how capital gains taxes work—and how you may be able to minimize them—is key to making more informed decisions.

What are capital gains?

A capital gain is the profit made from selling an asset that has appreciated while you've owned it. This includes stocks, bonds, real estate, collectibles, intellectual property and cryptocurrency.

To calculate a capital gain, you must first determine the cost basis. This is the amount you originally paid for the asset plus any additional costs associated with the purchase, such as fees, taxes or commissions. When calculating the cost basis for real estate, you may also include any capital improvements.

Then simply subtract your cost basis from the current value of the asset to determine your capital gain. Once you sell the asset, these unrealized gains become realized and subject to the capital gains tax. For example, stock purchased at $5,000 and sold at $7,500 would result in a realized gain of $2,500. Tax is owed in the year a gain is realized.

How are capital gains taxed?

Because capital gains represent an increase in your wealth, they're subject to federal taxes. Depending on where you live, realized gains may also be subject to state taxes.

The IRS determines the federal tax rate based on several factors. These include the type of asset sold, your income level, your filing status and how long you've held the asset.

• Long-term capital gains: An increase in value for assets held for longer than 1 year is considered a long-term gain and taxed at preferential rates of 0%,15% or 20%, depending on your taxable income.
• Short-term capital gains: An increase in value for assets held for 1 year or less is considered a short-term gain. The federal tax rate on short-term gains is typically less favorable because they're taxed at ordinary tax rates.

Generally, holding investments for the longer term is the only way to receive more preferential tax treatment. However, if you've received qualified dividends from stocks or mutual funds, these may also be taxed as long-term gains, even if you haven't held the underlying investment for at least a year. Just be aware that holding periods—ranging from 60 to 90 days—still apply, depending on the type of asset.

Capital gains tax on real estate

The rules surrounding capital gains taxes on real estate depend on the type of property you're selling. In general, the IRS offers more favorable tax treatment for capital gains on the sale of a primary residence than for the sale of a second home or an investment property.

Primary residence

When selling your primary residence, the IRS allows homeowners to exclude up to $250,000 of capital gains, or $500,000 for married couples filing jointly. This exclusion means many people don't pay much, if any, tax on the sale of their primary residence. To qualify for this exclusion, you must meet certain eligibility criteria. For example, to meet the residence requirement, you must have owned and lived in the home for at least 24 months out of the last 5 years before selling.

Second home or investment property

The IRS treats second homes and investment properties differently when calculating the capital gains tax. Unlike primary residences, gains from selling second homes and investment properties are fully taxable at either the short-term or long-term rate, without any exclusions, regardless of the time spent in the home.

Capital gains tax on inherited property

Assets passed to beneficiaries upon the original owner's death typically receive a stepped-up cost basis equal to the asset's fair market value on the date of the death. This effectively eliminates any prior capital gains that may have accumulated during the deceased's lifetime.

For example, let's say you inherited shares of stock from your grandfather. If he purchased the shares at $10 each but they were trading at $100 per share when he died, your cost basis would step up to the $100 value. If you later sell the shares for $120, you'd owe tax on the $20 difference between the sale price and the stepped-up basis of $100, rather than the original purchase price of $10.

The stepped-up basis rules can make inheritances a tax-efficient way to transfer wealth. However, potential changes to the tax code could eventually limit this benefit.

Capital gains tax on cryptocurrency

For tax purposes, the IRS treats cryptocurrency and other digital assets as property rather than currency. As a result, the sale, swap or use of a cryptocurrency may be subject to capital gains taxes, even if you didn't receive any cash proceeds.

This includes:

• Selling cryptocurrency for a profit
• Converting cryptocurrency to a fiat currency
• Using cryptocurrency to purchase goods or services
• Selling one cryptocurrency to purchase another

Each cryptocurrency transaction must be reported individually, so careful recordkeeping is a necessity. You should track the date, cost basis, sale price and holding period for every trade.

The tax rules surrounding cryptocurrency and other digital assets are still evolving, so it's a good idea to work with a tax professional experienced in this area.

Strategies to minimize capital gains taxes

While you can't completely avoid taxes on successful investments, you can take steps to reduce your capital gains taxes.

Make tax-smart investment decisions

When possible, aim for long-term gains. Holding investments for more than a year subjects your gains to more preferential tax treatment. Also, when choosing investments, consider assets that don't make large capital gains distributions, such as exchange-traded funds, or ETFs, and index funds. These are generally more tax-efficient than actively managed mutual funds.

You might also consider utilizing tax-advantaged retirement accounts. Individual retirement accounts, or IRAs, and 401(k)s allow your investments to grow tax-deferred—or even tax-free, in the case of Roth IRA accounts.

Be strategic when selling assets

If you're facing a high-income year—and thus a bigger tax bill—consider deferring the sale of appreciated assets to a future year when your income may be lower. You may also consider tax-loss harvesting, which allows you to offset capital gains with capital losses. You can even deduct up to $3,000 of excess losses against ordinary income.

Choose the optimal cost basis

When you open a brokerage account, a default cost basis method is typically assigned to your investments. While first in, first out, or FIFO, is a common default method, it may not be the best choice for everyone. There are many other methods to choose from, and it's important to choose the right cost basis method for your tax situation. For example, some methods—like specific share identification—may allow you to pick the most tax-favorable assets to sell.

Put your gains to good use

Donating highly appreciated assets to charity may be another strategy to consider. First, you'll avoid capital gains taxes on the appreciation. Second, if you itemize deductions on your tax return, you can take a deduction against taxable income for the asset's fair market value, giving you even greater tax savings.

Opportunity Zone funds might be another option to consider. Created under the Tax Cuts and Jobs Act of 2017, this option allows you to support economic development in low-income communities and defer taxes on capital gains by investing in a qualified fund.

Explore the QSBS exemption

If you hold private company stock, see if you qualify for the qualified small business stock, or QSBS, exemption. You may be able to exclude gains of up to $10 million or more if you meet certain conditions.

Work with a professional

Working closely with your wealth management team can help minimize surprises during tax season. Depending on your needs, your team may include a qualified tax professional, a wealth consultant or an investment advisor. They can model different scenarios, project your tax liability and optimize your investment strategy.

The bottom line

While taxes are inevitable, understanding how capital gains work can allow you to make smarter investing choices. By optimizing your asset mix, using tax-advantaged accounts and taking advantage of strategies to minimize your tax liability, you can keep your hard-earned investment gains working for you. As with any tax matter, consult a qualified professional for guidance tailored to your unique financial situation.