Understanding & Calculating Capital Gains Tax
Wealth can come from all sorts of assets. For individuals, assets may include a home, a vehicle, and personal-use items like home furnishings. When you sell one of these assets at a profit, you are responsible for paying taxes on it.
The profit generated from an asset sale is considered income by the federal government. You are taxed on the difference between the investment in the asset (what was paid for it) and the money that you receive. This is referred to as a capital gain. It is also possible to suffer a capital loss. This generally occurs when you sell an asset for less than the original amount you paid to purchase it.
Determining the Amount of a Taxable Capital Gain
The IRS determines an asset’s worth by figuring out its "cost basis" (definition here). For most assets, the cost basis is simply the amount you paid to acquire the asset. This includes any transaction fees or sales taxes that you may have paid. There are special rules for establishing this basis if you acquired the asset as a gift or an inheritance.
The basis may need to be adjusted for depreciation. This applies to assets that are not stocks and bonds. As a rule, stocks and bonds do not depreciate (even though they may decrease in value due to market fluctuations). For example, a car depreciates in value from year to year because it wears out over time.
Your capital gain is then the amount you received for selling the asset minus the asset’s basis. This is the amount that the IRS taxes.
Long-term capital gains are usually taxed at a lower rate compared to regular income. Most capital gains have a maximum tax rate of 15 percent. However, there are a few exceptions to this general rule.
A capital gain is considered long term if you held the asset for more than one year. The timer begins the day after you acquire the asset and includes the day that you sell it. Assets that you hold for less than one year are short-term assets. Short-term capital gains do not have the same tax advantages as long-term capital gains because they are often taxed at your regular income tax rate.
Capital losses can also be taken to offset capital gains. Meaning, if you sell one asset for a gain and another similarly held asset for a loss you would only need to pay taxes on the net profit of both assets. Allowing you to pay fewer taxes when you suffer capital losses in addition to gains.
Investing in assets that you intend to hold long-term can be a great tax advantaged way to invest. You will pay a reduced tax rate on the capital gains tax and, in many situations, you are only taxed on the asset when you dispose of it.