Understanding how capital gains tax impacts your investments
Capital gains tax is a federal tax you pay when you sell assets for a profit. Those assets could be stocks, bonds, cryptocurrency, real estate, and more.
The tax is levied on your profit – the difference between what you paid for the asset and what you sold it for.
Although that sounds straightforward, there are a few conditions surrounding capital gains tax you’ll want to understand to help you make smarter investment decisions. And maybe even keep more of your investment profit in your pocket.
Factors affecting capital gains tax
When you sell an asset for a profit, two factors determine the capital gains tax you may have to pay:
- How long you owned the asset
- Your income bracket
The long-term capital gains tax is levied on the profit from the sale of an asset you have held for more than one year. For the profit you make, the tax rate is 0%, 15%, or 20% depending on your income bracket (as of 2023).
The short-term capital gains tax is levied on the profit from the sale of an asset you have held for one year or less. This profit is taxed as ordinary income. In other words, you will pay the same tax rate on the profit as you pay on your income. Those tax rates are 10%, 12%, 22%, 24%, 32%, 35%, or 37% (as of 2023).
As you can see, there is potential for you to pay quite a bit more tax on the profitable sale of an asset if it is classified as a short-term capital gain.
Strategies to reduce your tax amount
When you make money investing, the government wants a cut. Understanding how capital gains taxes work is the first step to potentially lowering what you have to pay and keeping more of your investment profit. If you're nearing the one-year mark of holding an asset, you might consider holding it a bit longer to qualify for lower long-term capital gains tax rates.
Another strategy you may want to consider is tax-loss harvesting. The basic idea is to sell investments that have experienced a loss and use those losses to offset any capital gains realized through selling other investments for a profit to lower your tax liability. If the capital losses are more than the capital gains in a given year, the excess losses can be used to offset future capital gains. If the losses are significant, they can be carried forward for several years until fully utilized.
Additionally, there are some exemptions and deductions that may reduce the amount of capital gains from a home sale. For example, if you've lived in the property as your primary residence for a certain period (usually two out of the last five years), you may qualify for the home sale exclusion, which allows you to exclude a portion or all of the gain from the sale of your home.
It’s also worth noting that the sale of an asset for a profit could also trigger the net investment income tax (NIIT). This additional 3.8% tax is levied when your modified adjusted gross income (MAGI) exceeds $200,000 for a single filer and $250,000 if you are married and filing jointly.
When it is tax time, you report your capital gains as part of your federal tax return (Form 1040), using Schedule D.
As with any tax-related matter, it's advisable to consult with a tax professional for advice tailored to your specific situation as tax laws can be complex and subject to change. Local or state taxes may also apply, so understanding the relevant laws in your jurisdiction is important.
For more on capital gains and other investing topics, visit the Investor Education section of our Education Hub.
