How Capital Gains Taxes Work

by Miranda Marquit

When you sell an investment for more than you bought it for, the government wants a cut of the gains. You are required to pay taxes on your gains when you realize them, understanding that there are different rates, depending on how long you have held the investment.

You pay capital gains taxes only on the increase, though. So, if you bought an asset for $500, and it appreciates over time to $1,500, you don’t pay taxes on the $1,500 when you sell the asset. Instead, you only pay taxes on the gains — in this case $1,000.

Long-Term vs. Short-Term Capital Gains

How capital gains taxes work

Careful planning can give you excellent tax advantages

The rate at which you pay capital gains taxes is determined by how long you have held the asset. If you hold the asset for a year or less, it is considered a short-term investment. You are taxed at your marginal tax rate, meaning that the gain is treated as regular income.

If, however, you hold the asset for at least one year and one day, it is considered a long-term investment. When you sell, your gains are taxed at a rate that might differ from your marginal tax rate. Right now, those in the lowest two tax brackets don’t pay any federal capital gains taxes when they sell long-term assets. The top rate for capital gains is 15% for those in the 25% tax bracket or higher.

As you can see, there are tax advantages to holding investments for longer periods of time. If you expect your income to increase in the future, holding long-term assets can allow you to take advantage of the lower tax rate on your gains. Indeed, one of the reasons that many of the wealthiest pay at a lower tax rate is due to the fact that a large chunk of their incomes come from selling long-term investments. You might be in the 35% tax bracket, but if the bulk of your income comes as you sell long-held assets, you are only paying 15% on that income.

Special Exclusions to Capital Gains Taxes

Realize that there are special cases when it comes to capital gains taxes. Two items to consider include:

  • Home sale exclusion: If you sell your qualifying primary residence, you are exempt from paying on up to $250,000 in gains ($500,000 in gains if you’re married). This means that if your main home appreciates in value, and you have primarily lived in the property for at least two years out of the last five, you are eligible for an exemption in the need to pay taxes on the gains. Check with IRS to find out how to calculate qualifying and non-qualifying use on the home sale exclusion.
  • Collectibles: No matter how long you have held collectibles, the capital gains tax rate on them is 28%. Understand that physical gold is taxed as a collectible.

Will the Capital Gains Rate Remain the Same?

The capital gains tax rate, like all tax rates, is subject to change. Right now, the 15% cap on long-term capital gains taxes, as well as the ability for those in the lowest brackets to avoid paying long-term capital gains taxes altogether, is set to expire in 2013. There is talk of seeing the top long-term capital gains rate rise to 20%, and requiring everyone to pay. If this happens, you will likely see an increase in what you are paying right now. However, for those in the tax brackets 25% and above, even the increase still represents tax planning opportunities based on how much of your income is derived from long-term investments.

Published or updated June 14, 2012.
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