What is Capital Gains Tax?

Capital gains tax is a tax on your profits...

When you invest in the stock market — or in another type of asset — eventually, you might be able to sell your holdings for a profit. But you don’t get to bring home the bacon without the government getting a slice. That said, if you hold your investments over one year, you might increase the amount you get to keep (and reduce the amount that the government takes for itself).

Calculating whether you are required to pay capital gains tax is relatively straight forward. Let’s assume that an investor owns a capital asset (shares, bonds, property), and they decide to sell:

1. If the sell price is higher than the purchase price, then there is a potential capital gain. It is important to note that commissions and fees are included in the cost basis.
2. The next step is to determine how long the investor has held the asset. If they have owned the asset for less than a year, then they will need to pay capital gains tax at the same rate as normal income tax. Note: This is not always the case –- There are some exceptions to the rule, such as with collectibles (like stamps, coins, and baseball cards), being taxed up to 28%.
3. If the investor has held the asset for more than one year, then the transaction will fall into a different category. The tax will now range from 0% to 20%, depending on the investors’ annual income. It is important to note that there may also be state taxes to consider.
4. Another crucial consideration is capital losses that can be used to offset capital gains. If an investor has lost money from some capital asset disposals in the current year, or in previous years, then that may offset against gains. This can reduce how much the investor then has to pay.

An investor who owns shares or property for less than a year before selling for a gain falls into this category. The gain is taxed the same as regular income.

For an individual, these rates are as follows for 2020:

Someone who holds stock or property for more than a year before disposing of it for a profit will be deemed as a long-term investor, and the tax rate is significantly reduced.

Here’s the breakdown for individuals:

(Source: IRS,2020)

Investment property is treated differently than a main residence. If a single person lives in a property, then there is no tax up to a $250K gain. This also applies to a married couple; however, the amount there goes up to $500K.

This capital gains tax exemption does not apply if the individual has not lived in the house (i.e., it’s an investment property), is living overseas, or has not owned or lived in the house for 2 years in a 5-year period preceding the sale date.

A homeowner who has already used their $250K / $500L CGT tax credit in the last two years will not be able to apply for the exemption.

• 1913 – The 16th Amendment is ratified, giving Congress the power to tax individuals’ income, stating “Congress shall have the power to lay and collect taxes on incomes, from whatever source derived.”
• 1913-1921 — Capital gains are taxed at the same rate as other income, with rates up to 7%.
• 1922 - Capital gains tax was separated from personal income tax, and the top rate was lowered to 12.5% on capital gains, as opposed to the regular top tax rate of 73%
• The maximum capital gains tax rate on long-term capital gains topped out in the 1970s, around 40%, with major cuts following in the 1990s and 2000s.
• 2013 - Obamacare causes a reshuffle in the capital gains tax rate with a 3.8% net investment tax on capital gains, dividends and passive income added to the top rate for high-income earners.