Whenever you
sell an
investment at a
profit, you
will (in most
cases)
owe the
IRS a
tax known as a
capital gains tax. This is true for most
investments, including
mutual funds,
bonds,
options,
collectibles, your home, or
business.
Capital gains are the
amount by which an asset's
selling price exceeds its initial
purchase price. A
realized capital gain is an investment that has actually been sold at a profit. An
unrealized capital gain is an investment that hasn't been sold yet but would result in a profit if sold; the gain
equals the difference between the purchase price and the
selling price. The term capital gain is often used to mean realized capital gain. The opposite of a capital gain is a capital
loss, which occurs when the selling price of an investment is less than the purchase price.
In relation to your home, you may be
able to exclude the
gains from the sell of your primary
residence (the one you spend most of your time in) if you have lived in it for at least two consecutive years. The limit is $250,000 for
single taxpayers and $500,000 for married couples
filing jointly.
The IRS divides capital gains into two distinct categories, with each having different tax consequences.
Long-term capital
gains are gains on investments
held for more than a year, while
short-term capital gains are gains realized on investments that are held for a year or less. Short-term capital gains are taxed according to your
income tax bracket and long-term gains are taxed at 20% if you are in the 28% or higher tax bracket, and only 10% if you are in the 15% bracket. In other
words, long-term gains are
subject to lower
tax rates because the IRS
wants to encourage long-term
investing.
The Tax
Relief Act of 1997 created new
rules, including
low capital gains
rates on
assets held for more than five years:
If you are in the 15% income tax bracket you can take advantage of the five-year capital gains tax rates of 8%. This rate applies not only to investors who are single, but also to those married or filing jointly (granted you are still in the 15% tax bracket).
If you are in a higher tax bracket and your stocks and capital assets were acquired after December 31, 2000, you can take advantage of the five-year capital gains tax at a rate of 18%.
The
cost basis of your investment, the amount that was originally
paid for the investment, can be determined by several
methods:
If you purchased the investment, the cost basis is the amount you paid for it.
If you inherited the investment, the cost basis is the value of the stock on the date of the original owner's death.
If
you received the investment as a gift, the cost basis is the amount that was originally paid for the investment, unless the market value of the investment on the date the gift was given was lower.
To determine the capital gains tax on an investment, subtract the amount paid for the investment, including any
broker commissions, from the
sales price to arrive at the capital gain or loss. Then take this amount and multiply it by the appropriate
tax rate, which will give you the tax owed on the
sale of your investment.
In the case of a
mutual fund investment, you will likely have a
capital gains distribution, which is the profit that the mutual
fund made by selling
securities for more than their purchase price.
Federal law requires
funds to distribute the realized capital gains and income to investors at least once a year. The tax
status (short-term or long-term) of
capital gains distributions is determined by the
period of time that the mutual fund held the
underlying security that was sold, not by how long you were invested in the fund.
One effective
strategy for reducing
capital gains taxes is to sell money-losing investments in the same year that you have offsetting capital gains, thereby reducing your capital gains
taxes. In
fact, if you still have a
net loss
position after offsetting all your gains with equivalent-sized
losses, the IRS will allow you to apply as much as $3,000
per tax year toward a loss. If the losses are greater
than $3,000 you can carry those losses
forward to later years indefinitely. For example, some investors try to sell their money-losing investments within the first year, so they can
offset their highly-taxed short-term gains, while keeping their winners for more than a year whenever possible. There is one significant restriction on the use of this capital gains offset strategy. You cannot deduct losses from a
security if you repurchase the same (or a substantially identical) security with 30
days before or after the sale. This is known as the "Wash Sale Rule", and it prevents investors from abusing the strategy by selling at a loss for tax purposes and then simply repurchasing.
Wash Sale Rules are
complex, and we encourage you to read the IRS
guidelines about them.
Another capital gains
reduction strategy is through the use of a
tax-deferred account, such as an
IRA or 401(k).
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