If you have capital gains, that's usually a good thing. It means you sold an asset for more than you paid for it and made a profit.
Whether you sold stock, investment property, collectibles, or another capital asset, the profit may be subject to capital gains tax. Because capital gains are taxed differently than wages and other ordinary income, it's important to understand how the rules work before filing your return.
Here are five key things every taxpayer should know about capital gains tax.
1. Capital Gains Happen When You Sell an Asset for a Profit
A capital gain occurs when you sell an asset for more than its adjusted basis, which is generally what you paid for the asset plus certain additional costs.
Common capital assets include:
- Stocks and bonds
- Mutual funds and ETFs
- Investment real estate
- Collectibles
- Personal-use property
When calculating your gain, don't forget to include eligible expenses that increase your basis.
For example, if you spent money improving a property or restoring an item before selling it, those costs may increase your investment in the asset and reduce your taxable gain.
Example
You purchase an asset for $10,000 and spend $2,000 on improvements.
- Purchase price: $10,000
- Improvements: $2,000
- Total basis: $12,000
If you later sell the asset for $15,000, your taxable gain is generally $3,000 rather than $5,000.
Keeping good records can help ensure you only pay tax on your actual profit.
2. The Length of Time You Own an Asset Matters
Capital gains are classified as either short-term or long-term depending on how long you owned the asset before selling it.
Short-Term Capital Gains
If you owned the asset for one year or less, any profit is generally considered a short-term capital gain.
Short-term gains are usually taxed at your ordinary income tax rates, which are the same rates that apply to wages and salary.
Long-Term Capital Gains
If you owned the asset for more than one year, the gain is generally considered a long-term capital gain.
Long-term gains often qualify for lower tax rates, which can significantly reduce your tax bill.
Because of this difference, the timing of a sale can matter. In some situations, waiting a few additional weeks may allow a gain to qualify for long-term treatment.
3. Capital Gains Are Different From Business Income
Capital gains generally apply to profits from personal investments and property. Business income follows different tax rules and is reported separately on your tax return.
In some situations, determining whether an activity is an investment or a business can be challenging.
Example
Suppose you enjoy restoring classic cars:
- If you occasionally restore and sell a vehicle, the profit may be treated as a capital gain.
- If you regularly buy, repair, and sell vehicles with the intention of making a profit, the activity may be treated as a business.
The IRS considers factors such as profit motive, frequency of activity, recordkeeping practices, and whether the activity is operated in a businesslike manner.
If you're engaged in ongoing buying and selling activities, you may need to report the income as business income rather than capital gains.
4. Most Homeowners Can Exclude Gain on the Sale of Their Home
For many taxpayers, their home is their largest asset.
The good news is that most homeowners can exclude a significant portion of the gain from the sale of a primary residence.
To qualify for the exclusion, you generally must:
- Have owned the home for at least two years during the five-year period before the sale.
- Have used the home as your primary residence for at least two years during the same five-year period.
- Not have claimed the home sale exclusion on another property within the previous two years.
If you meet these requirements, you may be able to exclude:
- Up to $250,000 of gain if filing as Single.
- Up to $500,000 of gain if Married Filing Jointly.
Many homeowners sell their primary residence without owing capital gains tax because their gain falls within these exclusion limits.
5. Capital Losses Can Help Offset Capital Gains
While gains increase taxable income, capital losses can help reduce it.
If you sold investments at a loss during the year, those losses generally offset your capital gains before your tax is calculated.
Example
- Capital gains: $8,000
- Capital losses: $3,000
Net capital gain: $5,000
Only the net gain is generally subject to capital gains tax.
It's important to note that losses on personal-use property are generally not deductible. For example, if you sell a personal vehicle for less than you paid for it, the loss usually cannot be claimed on your tax return.
Investment losses, however, may provide valuable tax benefits.
Keep Accurate Records
Good recordkeeping is one of the best ways to manage capital gains taxes.
Be sure to keep:
- Purchase records
- Sale records
- Brokerage statements
- Closing statements for real estate transactions
- Documentation of improvements and repair costs
- Records of commissions, fees, and other transaction expenses
These documents help establish your basis, support your gain or loss calculations, and may be needed if the IRS requests additional information.