If you’ve ever made a profit on an investment, chances are you’ve paid a capital gains tax. Simply put, a capital gain is the profit an investor makes from their investment and a capital gains tax is the tax on that profit. Depending on your income tax bracket and the length of period that you held that investment, the capital gains tax on the money you made could very quickly curb your excitement over a significant return.
In fact, the capital gains tax rates are expected to increase after 2010, due in large part to the pending expiration of the Bush tax cuts from 2003. The rate applies to any investment–most commonly stocks, bonds, commodities and property–where the purchaser bought the asset at a lower price than what it is sold it for. Dividends are also eligible to be taxed as well, although at a different rate.
Here’s how you can figure out how much taxes you should be paying on your capital gains.
Capital Gains Tax Rates
First off, to know how much your profits are going to be taxed, you need to figure out how long you’ve held the investment. Long-term capital gains, which are investments that were held for a year or longer–are taxed at 15 percent in 2010 and 20 percent if the tax cuts expire. If you’re in or below the 15 percent bracket, your capital gains actually aren’t taxed in 2010, and “only” at 10 percent in 2011 and beyond.
Short-term capital gains (investments held for shorter than a year) in 2010 are taxed at your current highest tax bracket. If the cuts expire, they are taxed at your current highest tax bracket plus three percent. So if your income tax bracket is 25 percent, your short term capital gains will be taxed at 28 percent.
Keep in mind that the capital gains tax doesn’t take into effect until the profit on the asset is realized. In other words, if a stock you own goes up in value, you won’t be taxed on it until you sell it for a profit. If you like to trade stocks, you should factor in the tax implications of constantly buying and selling shares of a company or investing in it long term.
Capital Gains Tax on Property
While property is taxed the same as other investments, you can exclude up to $250,000 (or $500,000 for married couples) on the profit of the property sale if it served as your main residence in two of the last five years. If you fail to meet that requirement, you could still try for partial exclusion for special circumstances like having to relocate for work, health reasons, divorce and so on.
We’ll cover capital losses in a second, but you can’t file for a capital loss if your home was your main residence. Capital losses on property are only tax deductible if they were strictly an investment and did not serve for any personal use.
Capital Loss Deductible
While the government is more than willing to take their share of your profits, they’re also willing to help you out to cover your risks. A capital loss is the opposite of a capital gain. It’s when you sell an asset at less than what you paid for it originally, also known as your cost basis. That capital loss can be written off as a tax deduction, but the IRS allows a capital loss deduction of no more than $3,000 per year. If your losses are greater than that, you can carry it over to the following year.
Capital gains taxes only apply to the net profit an investor makes. For example, if you had two investments and one made $100 but the other one lost $80, your final taxable capital gain is only $20. To take advantage of this, many investors use what is known as tax loss harvesting. To protect their short-term gains from higher taxes, they realize their investment losses to offset the net balance. This is particularly noticeable in the month of December.
Filing Your Capital Gains Taxes
You don’t necessarily need a tax accountant to file your profits or losses if you already do your own taxes. That is, of course, if you’re just a basic investor that can keep track of your investments. Capital gains and losses are reported in a Schedule D tax form.
If you do have many complex investing strategies, or want to maximize the tax efficiency of your investments, it would be a good idea to consult an advisor. The Schedule D form can be quite complex for those unfamiliar with it and keeping track of many investments and positions can be troublesome for some.
Whether or not you need a financial professional to handle your capital gains taxes really depends on your acumen in tax filing and your activity and sophistication level as an investor. Taxes, as you probably know by now, aren’t something to play around with. Uncle Sam wants his money and he wants it on time. If you aren’t sure how your investments are going to be taxed or if you just cashed out on a major investment, it’s probably a good idea to speak to an accountant.
