What you should know about capital gains tax

The sale of certain assets can trigger capital gains tax. Understanding how capital gains tax works and the capital gains tax rate can lead to significant tax savings.

What is capital gains tax?

Capital gains tax applies to capital gains from the sale of capital assets. The IRS considers almost all assets not used in a trade or business to be capital assets. Certain assets like stocks and bonds qualify as capital assets even if owned by a business. Profit on the sale of capital assets—called a capital gain—usually receives preferential tax treatment compared to most other types of income.

How does capital gains tax work?

Knowing the amount and type of capital gain or loss created by asset sales allows you to calculate capital gains tax.

Capital gain on the sale of a capital asset equals the sale price minus the asset's "adjusted basis." Adjusted basis means the cost initially paid to buy the asset—called the cost basis—plus additions such as improvements minus subtractions like depreciation.

The type of capital gain significantly affects the capital gains tax rate. Short-term capital gain usually applies to assets sold one year or less after acquiring them. Assets held for more than a year typically generate long-term capital gains.

Common exceptions that have their own rules for calculating basis and determining the type of capital gain generated include gifts, inheritances, and like-kind exchanges.

Subtract short-term capital losses from short-term capital gains to determine net short-term capital gain or loss. The same process—called netting—applies to calculate net long-term capital gain or loss.

If you have a short-term capital gain and a long-term capital loss—or vice-versa—net the two numbers again by subtracting the loss from the gain to determine the total net capital gain or loss. However, keep short-term capital gain or loss separate from long-term capital gain or loss if both are losses or both gains—different tax rates apply to each.

Net capital losses can offset up to $3,000 of ordinary income. Any excess loss applies to future years to offset capital gains first, then up to $3,000 of ordinary income per year.

How much is capital gains tax?

Ordinary tax rates apply to short-term capital gains.

The long-term capital gains tax rate equals 15% for most taxpayers on most types of capital gain. Individuals with taxable income of less than $40,400 ($80,800 for married couples filing jointly) pay no tax at all on 2021 capital gains. However, a 20% capital gains tax rate applies to 2021 capital gains for individuals with taxable incomes over $445,850 ($501,600 for married couples filing jointly). IRS Tax Topic No. 409 provides up-to-date capital gains tax income thresholds for all filing statuses.

Common exceptions to normal capital gains tax rates include:

• Collectibles. Long-term capital gain from the sale of collectibles—such as art and antiques—gets taxed at a maximum of 28%.
• Investment real estate. A maximum 25% tax rate applies to any depreciation previously taken when selling investment real estate—property not used as the primary residence or in a trade or business. This is called depreciation recapture or Section 1250 gain. Section 1250 gain cannot exceed the total long-term capital gain from the sale.
• Qualified small business stock. The greater of $10 million or ten times the adjusted basis of qualified small business stock avoids capital gains tax entirely. Any capital gain exceeding this amount gets taxed at a maximum of 28%.
• Primary residence. An individual can exclude $250,000 ($500,000 for married couples filing jointly) of capital gains on the sale of a personal residence from taxable income.
• Personal-use property. For tax purposes, personal-use property can only create capital gains, not capital losses. Examples of personal-use property include the primary residence and cars not used in a trade or business.

A separate 3.8% net investment income tax applies to the investment income of individuals with a modified adjusted gross income (MAGI) over $200,000 ($250,000 for married couples filing jointly). Investment income includes capital gains.

Holding on to property long enough to qualify for long-term capital gains tax rates and timing asset sales to occur when your taxable income is low can offer impressive tax savings.