What is Capital Gains Tax?

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Definition:

Capital gains tax is a mandatory fee, charged by the government when a person sells an asset (e.g., shares or property) for a profit.

🤔 Understanding capital gains tax

When you profit on an investment, you should probably know how much goes to the government. Capital gains tax applies to both individuals and businesses. It's payable when a capital asset (e.g., stocks, bonds, real estate) is sold, and a gain is realized.

Capital gains fall into two categories: short-term and long-term. Short-term capital gains — profits on assets held less than one year — are taxed as ordinary income. For instance, if you’re in the 24% federal tax bracket, you’ll pay taxes at that rate, or even higher if the gain bumps you into the next tax bracket. Typically, long-term capital gains are treated more favorably. They’re “realized” when an asset is sold after being held for more than one year, and depending on your tax bracket, the long-term capital gains tax rate is either 0%, 15%, or 20%.

Example

Let’s assume an investor bought shares in the fictional company Alma’s Almanacks less than one year ago, and their market value has risen steadily. The investor decides to sell the stock. As they have held the shares for less than one year, the investor would be subject to short-term capital gains tax, which is taxed at the same rate as their personal income. However, if the investor sells their shares for a profit after more than one year, they would be subject to a reduced capital gains tax (ranging from 0% to 20%, depending on the investor’s income tax bracket). State taxes may vary.

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When do you owe capital gains tax?

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

  1. If the sales price is higher than their purchase price, then there is a potential capital gain. It's 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 one year, then they will need to pay capital gains tax at the same rate as normal income tax. Note: There are some exceptions to this rule, such as with collectibles (like stamps, coins, and baseball cards), which may be taxed at a higher rate.
  • If the investor has held the asset for more than one year, then their profit will be taxed differently. The tax will now range from 0% to 20%, depending on the investor’s annual income. State taxes may vary.

Remember, capital losses may help offset capital gains. If an investor has lost money in the current year, or in previous years, then that may help offset against some gains. This can reduce how much the investor has to pay in taxes.

What are the current capital gains tax rates?

Short-Term Capital Gains Tax

An investor who owns shares or property for less than one 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 (taxes due spring 2021) and 2021 (taxes due spring 2022):

Capital gains tax rate2020 Taxable income2021 Taxable income
10%$0 to $9,875$0 to $9,950
15%$9,876 to $40,125$9,951 to $40,525
22%$40,126 to $85,825$40,526 to $86,375
24%$85,826 to $163,300$86,376 to $164,926
32%$163,301 to $207,350$164,925 to $209,425
35%$207,351 to $518,400$209,426 to $523,600
37%$518,401 and up$523,601 and up

Long-Term Capital Gains Tax

Someone who holds stock or property for more than one year before selling for a profit will be deemed a long-term investor, and their tax rate might be significantly reduced.

For an individual, here's the breakdown of long-term capital gains tax rates for 2020 (taxes due spring 2021) and 2021 (taxes due spring 2022):

Capital gains tax rate2020 Taxable income2021 Taxable income
0%$0 to $40,000$0 to $40,400
15%$40,001 to $441,450$40,401 to $445,850
20%$441,451 and up$445,851 and up

Property Sales Tax

If a single person lives in a property and they sell it for a profit, then there is no tax on up to a $250,000 gain ($500,000 if married).

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 / $500K CGT tax credit in the last two years will not be able to apply for the exemption.

Are there strategies that can reduce capital gains tax?

Yes, there are some strategies to reduce capital gains tax. Here are a few examples.

Gifts

Family gifts can be used to reduce a capital gains tax bill. Each year a family member can give up to $15,000 to another family member as a gift. A married couple can give up to $30,000. So, if you give an asset that has appreciated to a family member who's in a lower tax bracket, together you can minimize the tax burden on your family.

Loss taking

An investor who has capital losses or carried over capital losses from previous years may be able to reduce their capital gains tax.

Just Hold On

An obvious alternative to paying short-term capital gains tax is to just hold onto your investment. Typically, after the one-year mark, a person’s capital gains tax liability is significantly reduced. Of course this should be considered in context with your overall investment strategy

Disclosure

Robinhood does not provide tax advice. Please consult with a tax professional regarding your personal circumstances.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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