How Capital Gains and Losses Affect Your Taxes
LH
Last updated 03/21/2024 by
Lee HuffmanDid you receive a Schedule D (Form 1040) in the mail this tax season? If so, you must have sold assets in the past year. If you made a profit on your sale, you’ll have to pay taxes on it; and if you lost money, that loss can reduce your tax liability. But regardless of whether you made or lost money, you must report capital gains and losses on your tax returns.
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What are capital gains and losses?
Capital gains and losses happen when a person or business sells an asset that was held for personal or investment use. If the asset is sold for a profit, that profit is a capital gain. When it is sold for less than it was purchased for, the loss is a capital loss.
Short-term vs. long-term capital gains and losses
Assets held for less than one year before sale are considered short term. Long-term capital gains and losses occur when an asset is sold after being held for one year or longer.
Netting capital gains and losses
First, sort your capital gains and losses based on whether they are short-term or long-term. Then, net all short-term capital gains and losses against each other. The same process applies for long-term.
Can short-term capital losses offset long-term capital gains?
Yes, just make sure you follow the IRS requirements when you do so.
First, add up all your short-term gains and losses. Then do the same for long-term gains and losses. If there are losses of either type left over, then those losses can offset gains of the other type (and vice versa).
Once you’ve netted all your short- and long-term gains and losses:
- If there are capital losses remaining, you can reduce your income by a maximum of $3,000.
- If there are capital gains remaining, you must pay taxes on those gains.
Do you have more than $3,000 of capital losses, even after accounting for capital gains? If so, those losses will roll over into the following year. Next year, you can treat the carried-over losses as if they occurred during that year. This process continues until you exhaust all of your capital losses.
If you own investments that are doing badly, it sometimes makes sense to sell them to offset gains or income. This practice is called tax loss harvesting. It is an effective way to use the short-term capital losses of investments to offset your gains.
Here’s a simple example of how tax loss harvesting works
Let’s say you made some savvy investments in Netflix and earned $5,000 in the last 12 months. You want to minimize your tax liability so you look for stocks in your portfolio that are underperforming. You notice your shares in Nike are going through a temporary slump and you’re $2,000 in the red. If you sold your Nike shares you could reduce your taxable gains from $5,000 to $3,000.
If at this stage, you are wondering whether you can sell stocks that are temporarily underperforming for the tax benefits and then buy them back, congratulations. That could be a winning strategy if it weren’t for a pesky tax law: the 30-day rule — also known as the wash sale rule.
What is the 30-day rule and how does it affect tax-loss harvesting?
The 30-day rule requires investors to hold off a minimum of 30 days from buying back investments used to offset gains. If you don’t wait 30 days, you are no longer allowed to use the losses to reduce your taxable gains. The purpose is to limit the opportunistic sale and purchase of long-term investments to save on taxes.
However, this rule does not work both ways. The IRS will happily tax you for the full amount of your gains if you sell and rebuy investments that made a profit. No wonder tax professional call this law the heads I win, tails you lose rule.
Paying taxes on capital gains
Taxpayers must pay a capital gains tax when they sell assets for a profit. For most people, this happens during the sale of stock, bonds, mutual funds, or real estate.
If you buy $600 worth of shares in a company and then sell them for $800, this is an example of a stock gain. If this sale happens within one year of buying the shares, the $200 profit is a short-term capital gain. After one year or longer, that is a long-term capital gain.
Most people who pay capital gains pay a 15% rate. You have to make more than $510,300 (or $612,350 for married couples filing jointly) to pay the top 20% capital gains tax bracket.
Are capital gains income?
Yes, capital gains qualify as income. However, the tax rates on your capital gains vary based upon how long you owned the asset.
The IRS taxes short-term capital gains like ordinary income, such as your paycheck from your job. Long-term capital gains, on the other hand, are taxed at lower rates. This is because the government favors longer-term investing.
Capital gains tax rates
The IRS applies different capital gains tax rates depending on how long you held the asset before selling, and what type of asset was sold.
Short-term capital gains are taxed as ordinary income with tax rates up to 37% for 2018. If your income is high enough, your capital gains could be subject to an additional 3.8% Medicare surtax.
But the tax rates on long-term capital gains vary. You can view capital gains tax rates based upon your marginal income tax bracket below:
| Income Tax Bracket | Short-Term Capital Gains | Long-Term Capital Gains |
|---|---|---|
| 10% | 10% | 0% |
| 12% | 12% | 0% |
| 22% | 22% | 15% |
| 24% | 24% | 15% |
| 32% | 32% | 15% |
| 35% | 35% | 15% |
| 37% | 37% | 20% |
If you’re wondering what rate you would have to pay, here are the income tax brackets for 2019 based on your filing status.
| Rate | Unmarried Individuals, Taxable Income Over | Married Individuals Filing Joint Returns, Taxable Income Over | Heads of Households, Taxable Income Over |
|---|---|---|---|
| 10% | $0 | $0 | $0 |
| 12% | $9,875 | $19,750 | $14,100 |
| 22% | $40,125 | $80,250 | $53,700 |
| 24% | $85,525 | $171,050 | $85,500 |
| 32% | $163,300 | $326,600 | $163,300 |
| 35% | $207,350 | $414,700 | $207,350 |
| 37% | $518,400 | $622,050 | $518,400 |
As you can see, most people who pay capital gains pay a 15% rate. You have to make more than $510,300 (or $612,350 for married couples filing jointly) to pay the top 20% capital gains tax bracket.
Notable exceptions to long-term capital gains tax rates include:
- Married homeowners can exempt up to $500,000 in capital gains gained by selling their primary residence. Single taxpayers may exempt up to $250,000. For this exception to apply to you, you must have lived in the home for two of the previous five years before it was sold.
- Sales of Section 1202 qualified small business stock have a maximum tax rate of 28%.
- The IRS taxes collectibles (such as coins and art) at a maximum of 28%.
- Unrecaptured Section 1250 gains from selling real estate are taxed at a maximum of 25%.
Still confused about capital gains?
Calculating capital gains and minimizing your tax liability can get complicated fast. Hiring a tax professional, such as a tax lawyer or accountant may be the smart move if you’re new to investing or you’re unsure how new taxation laws apply to you.
Some investment advisers and wealth management companies offer this service as a perk to investors.
LH
Lee Huffman is a former financial planner and corporate finance manager who now writes about early retirement, credit cards, travel, insurance, and other personal finance topics. He enjoys showing people how to travel more, spend less, and live better.
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