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What is Capital Gains Tax?

definition

Capital gains tax (CGT) is a levy that is payable when an asset (e.g., shares or property) is sold for a profit.

🤔 Understanding capital gains tax

Capital gains tax (CGT) applies to both individuals and businesses. It is payable when a capital asset (stocks, bonds, real estate property, jewelry, etc.) is sold, and a gain is realized. Long term capital gains are “realized” when an asset is sold after being held for more than a year. Depending on an individual’s tax bracket, the rate is either 0%, 15%, or 20%. Short term capital gains — on assets held less than a year — are taxed as ordinary income. Capital gains can be offset by capital losses, which are realized when an asset is sold for less than its purchase price.

example

Let’s assume that an investor bought a property less than a year ago, and the price has risen steadily. They decide to sell the house and capitalize on the profit. As they have held the property for less than the 1 year, they would be subject to short-term CGT, which is taxed at the same rate as personal income. However, if the investor holds the property for more than a year, he or she will be liable for a reduced rate of CGT (typically from 0% to 20%, depending on the investors’ income tax bracket). It is important to note that there also may be state taxes with different rules and rates to take into account.

Takeaway

Capital gains tax is like an income tax for your money...

When you put your money to work in the stock market — or in another type of asset — it doesn’t get to bring home the bacon without the government getting a slice. You can keep the government's slice a little smaller by playing the long game.

Tell me more...

How to calculate capital gains tax?
What are the current capital gains tax rates?
Property Sales Tax
What is the history of capital gains tax?
Are there strategies that can reduce capital gains tax?

How to calculate capital gains tax?

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.

What are the current capital gains tax rates?

Short term

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:

Taxable incomeCapital gains tax rate
$0 to $9,32510%
$9,325 to $37,95015%
$37,950 to $91,90025%
$91,900 to $191,65028%
$191,650 to $416,70033%
$416,700 to $418,40035%
$418,400 and up37%

Long term

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:

Taxable incomeCapital gains tax rate
$0 to $9,3250%
$9,325 to $37,9500%
$37,950 to $91,90015%
$91,900 to $191,65015%
$191,650 to $416,70015%
$416,700 to $418,40015%
$418,400 and up20%

(Source: IRS,2019)

Property Sales Tax

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.

What is the history of capital gains tax?

  • 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.

Are there strategies that can reduce capital gains tax?

The short answer is yep. Some of the strategies that can be used to reduce CGT are:

Gifts

Family gifts can be used to reduce a capital gains tax bill. Each year a family member can give up to $14K to another family member in the form of a gift. A married couple can give up to $28K. So, if you gift the appreciated asset to a family member in a lower tax bracket, and its value is less than the gift tax limit, you can avoid capital gains tax — and the recipient (should they choose to sell the asset) pays taxes at his or her income tax rate.

Loss taking

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

Home improvement

Home sweet home! Renovations could mean a significant reduction in capital gains tax.

If your renovations increase the price of your home, they can be added to the cost basis — subject to limits by the IRS.

Savings plans

Insurance and healthcare savings plans can be used to reduce a tax bill. A 529 college savings plan allows the owner to deposit money into the plan and eventually pull it out without triggering a capital gains tax event as long as used for qualified educational expenses. Healthcare savings accounts (‘HSAs) are similar, with the potential growth in the account tax-free.

Interstate

Relocating interstate is another option for someone who wishes to reduce their capital gains tax. With capital gains tax, there is a federal and state levy. Moving to somewhere like Florida, where there is zero capital gains tax, could mean that only the federal amount needs to be paid. To take advantage, you would need to be a resident of the state before selling the asset.

Just Hold On

An obvious alternative is just to hold on and not sell – particularly if it is the difference between 6 months and a year. Once past the long-term mark of one year, the capital gains tax liability is significantly reduced.

20191119-1015323-3059244

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