How are Capital Gains Taxes Calculated?

Capital gains taxes stand to take a big chunk out of your profits when you sell an asset. However, like most taxes, there are many things that go into the exact calculations of the capital gains tax you will pay. Remember that capital gains tax applies to a variety of different assets, including stocks, property and businesses. A unique factor of capital gains tax is that the amount of tax depends heavily on how long you had the asset. Depending on the state you live in, the state government may also levy capital gains taxes in addition to the federal government.

What Are Short-Term Capital Gains Taxes?

This variety of capital gain tax applies to the sale of an asset that you have held for no more than one year. In this instance, the capital gains tax will be equal to what your income tax rate is. Short-term capital gains taxes are higher than long-term rates. There is no 0% or 20% ceiling for capital gains taxes if they are short-term, which is why many investors try to hold on to their assets for longer than a year.

What Are Long-Term Capital Gains Taxes?

If you have held an asset for longer than a year, the IRS will apply long-term capital gains taxes to the sale. The long-term rate can vary depending on your filing status and taxable income at the time you sell the asset. In 2020, the rate could be 0%, 15% or 20%.

What is a “Basis?”

Another important component to understand when calculating your capital gains tax is the “basis.” The “basis” is how much money you originally paid for the asset. So, if you bought stocks for $500, your basis is $500. The actual amount of capital gains tax starts from the difference between how much you sold the asset for and the basis. If you sold your stocks for $600, then the difference between the basis and the amount of profit is $100. The capital gains tax will apply to the $100 profit, and it will either be short-term or long-term, depending on how long you have owned the stocks.

Why Are Capital Gains Taxes Different from the Regular Income Tax?

Essentially, because the government does not view money generated from work and money generated from investments the same way. The technical term for this is “earned” income and “unearned” income. The money you make from work is “earned” income, and this applies whether you got the money by virtue of flipping burgers or being CEO of Amazon. “Unearned” income has its basis in dividends, interest and capital gains. (The term “unearned” does not mean that the money does not belong to you or that the IRS is punishing you for having it. This is merely nomenclature to differentiate this income from a paycheck.)

How Can I Avoid Capital Gains Taxes?

One of the best ways to avoid capital gains taxes on either short or long-term investments is with a Deferred Sales Trust. Contact us today at Reef Point to learn more about how we can help shield your profits from capital gains taxation.