If not tracked and managed properly, capital gains tax can come as a large surprise at tax-filing time. In fact, many taxpayers don't realize they have a capital gain until they get their 1099 form in January and see a capital gain distribution. Here's what you need to know.
Understand capital gains and their taxability
Capital gains are recognized when you sell a capital asset for more than your basis in that asset. Capital assets are typically something of value like your home, a car and other investments. Basis is typically the original cost of the asset being sold. The difference between the sales price of the asset and your basis is the amount of the taxable capital gain.
The IRS taxes short-term capital gains for assets owned less than one year as ordinary income up to 37 percent, but taxes long-term capital gains at a maximum 23.8 percent (20 percent plus a potential 3.8 percent net investment tax).
Ways to manage capital gains tax
Hold investments for more than one year. Long-term gains (assets sold more than a year after acquisition) are taxed at the lower capital gains rate. If you are able to hold assets for more than a year, you will save tax dollars by avoiding the gain being classified as ordinary income.
Sell large gains in low-income years. If you expect lower income this year, it might be a good time to sell some of your capital gain investments. Since the capital gains tax brackets follow the marginal income tax brackets, if you are in a lower income tax bracket in a given year you may pay a lower capital gains tax. You can take advantage of this with both long-term and short-term gains.
Harvest large losses in high-income years. If you have a high-income year you can save taxes by selling investments that have lost money. Capital losses help reduce your capital gains with the tax liability calculated on the net amount. Be aware of IRS netting rules that require you to net long-term losses with long-term gains and short-term losses with short-term gains. If one results in a net loss and the other a net gain, they are then netted against each other. If the final amount results in a net loss, the most you can deduct against ordinary income in one year is $3,000. The excess losses must then be carried forward to future tax years.
Gift your investments to your kids. You are allowed to gift up to $15,000 per year to each of your kids ($30,000 per married couple). If you gift appreciated investments to a child under 19 and they then sell that investment, each child can receive favorable tax treatment on up to $2,100 from their taxes. Be careful if you go over the annual exemption. Higher levels of unearned income for children, including capital gains, is now subject to estate and trust tax rates.
Consider donating property. If you donate appreciated property to a qualified charity you can deduct the donation as an itemized deduction. Even better, if the property is owned by you for more than one year, you can deduct the current market value without being subject to capital gain tax.
Sale of primary residence exclusion. If you sell your home, you may qualify to exclude $250,000 of the gain from capital gains tax ($500,000 if married filing jointly). In order to qualify, you need to own the home and have occupied the home as your primary residence for at least two of the previous five years. The two years do not need to be simultaneous.
There are many factors that come into play when buying or selling an asset. Just make sure the tax implications are considered before you make the transaction.