A capital gain is the money made through the sale of assets at a higher value than the purchase price. It is considered to be taxable income for the IRS, regardless of whether is realized in the short-term (less than one year) or long-term (more than one year).
Capitals gains are considered by the IRS to be a different form of income from regular income, such as earned wages from a job. Common capital assets can include things like a mutual fund, stock, bond, home, car, and various collectibles. Adding in an extra layer of complication, the length of time you hold a capital asset makes the world of difference in terms of how much tax you owe on any gains.
Even within the range of assets that count towards capital gains, the IRS differentiates between certain kinds of capital assets and others. It also taxes capital assets differently if they are held within a 401(k) or IRA versus a regular stock brokerage account or even inside a safe in your house.
What is capital gains tax?
The simplest definition of a capital gain is the difference between the price an asset is sold for and the price it at which it was bought (also known as the cost basis). For example, if you were to sell a house for $150,000 but bought it for $125,000, you will have made a capital gain of $25,000.
The same rule for determining taxable gains applies to other assets, such as shares of a stock. Let’s say you buy shares of Company XYZ for $10 and then sell it for $15; you made a profit of 50%, which might worry you because it seems like a large gain. But what matters to the IRS is your dollar gain, not your percent gain. In this case, each share netted you $5 in capital gains; that $5 is then taxable.
The percent by which it is taxed is a separate consideration. If this were the only stock you sold in a year and it was purchased more than a year prior to selling it, that $5 would fall into the category of long-term capital gains.
Your income tax bracket can directly affect your capital gains tax liability. According to the IRS, if your taxable income for the year was below $78,750 and you are a single filer, you don’t owe anything on that $5 extra you made by selling a stock at a higher price. If your taxable income was between $78,750 and $434,550 during that year, your tax rate will be 15% on that $5. And if you made $434,551 or more during that tax year, your capital gain tax rate for that stock would be 20%.
But guidelines for taxation are subject to change depending on the particular circumstances surrounding how you held the asset, as well as on your filing status. If you held that stock inside an IRA or if you held it for less than a year, you will be subject to different taxation percentages. It would also be different if you also had other stocks or investments that sold for less than you bought them for. Those are capital losses, and they can offset some capital gains and effectively reduce your tax bill.
Before we dig into all of those details, let’s step back and define capital assets. For what kinds of assets do you have to pay capital gains taxes on in the first place?
What are capital assets?
The basic definition of a capital asset is something that either contributes to the ability of a business to generate profit, or that is a piece of property of significant value to an individual. The definition of “significant” can be a bit flexible, with the IRS even noting, “Almost everything you own and use for personal or investment purposes is a capital asset.”
On the business side, common capital assets include things like property, machinery, inventory, and intellectual property. For individuals, we’ve already mentioned the main ones: stocks, bonds, houses, cars, and collectibles.
While all of these property items are considered capital assets, they are not necessarily all taxed in the same way. In the example above, $5 in price appreciation from a stock is taxed at 0%, 15%, or 20% depending on your tax bracket. But if that $5 came from selling a collectible or piece of art, it would be taxed at your ordinary income rate up to 28%.
There are some specific rules about how different types of assets are taxed, with special rates as well as exceptions existing for several different asset types. We will go into more detail on this in the next section.
How are short-term capital gains, long-term capital gains, and capital losses taxed?
Short-term and long-term capital gains
To start, you need to be clear on the difference between a short-term and long-term capital gain. The way in which your profit or loss from buying and then selling a capital asset is primarily determined by how long you held the asset.
If you sell a capital asset within one year of purchasing it, the capital gain is considered to be short-term. If you hold the capital asset for at least one calendar year plus one day, then your capital gain is technically a long-term one.
Short-term capital gains are taxed exactly the same as regular income, at your regular income tax rate.
Long-term capital gains are taxed under a different set of tax brackets. As we saw with the example above of long-term gains on stocks, there are generally rates of 0%, 15%, and 20% depending on individual income as well as filing status.
There are, however, exceptions to these rules:
- Gains from the sale of a home you’ve lived in two of the previous five years are only taxed after the first $250,000 ($500,000 if married filing jointly). Unfortunately, if the home is sold for less than the price for which it was bought, that is not considered to be a tax-deductible capital loss (we will cover this more in the next section).
- Special deductions exist for individuals who have invested in real estate, to account for long-term deterioration as well as necessary renovations. This does likely help raise the taxable capital gain if you decide to sell the property.
- Gains from small business stock are exempt if they are under $10 million and if the shares were both bought after August 10, 1993, as well has held by the individual taxpayer for at least five years before the sale.
- Gains from collectibles are always taxed at 28%. Collectibles include art, jewelry, antiques, and even precious metals (outside of an IRA).
Capital gains are also taxed a bit differently for high-earning individuals, following a special tax known as the net investment income tax. An extra 3.8% tax is assessed on investment income in excess of specific modified adjusted gross income (MAGI) thresholds:
- $200,000 for single filers or a head of the household
- $250,000 for married couples filing jointly
- $125,000 for married couples filing separately
Although nobody likes to lose, declaring capital losses when filing taxes can actually help reduce your tax bill.
If you have taken any losses from selling a capital asset during the year, you can likely offset some of the gains you’ve taken. In general, this is “like for like.” Meaning, a short-term capital loss directly offsets a short-term capital gain. The same is true with long-term gains and losses.
In fact, if you have excess losses of one type after you deduct from its partner gains (say $1,000 in short-term losses and only $500 in short-term gains), then the remainder can be used to offset the other type ($500 short-term losses leftover can offset any long-term capital gains).
If you have a total net capital loss on the year, you can then use whatever you have “left” to offset up to $3,000 in other income for the year. So, in the above example, you had $500 in short-term losses carried over after offsetting $500 of short-term capital gains. If you have no long-term capital gains or losses, this leaves you able to then deduct $500 from your ordinary income.
What can you do with an IRA to save on capital gains taxes?
The answer is that an IRA can be your solution to purchasing capital assets and only paying income taxes on them—and generally even these are tax-deferred.
This is because non-Roth retirement accounts are tax-deferred retirement savings vehicles. If you contribute income received at any point throughout the year to an IRA, you don’t have to pay taxes on it until retirement. Then, at retirement, your distributions are taxed as ordinary income. For Roth IRAs, the opposite is true: you are taxed up front and receive tax-free distributions at retirement.
And within a self-directed IRA (SDIRA), you can purchase assets like gold and silver while also leveraging the tax-deferred status of an IRA, or in the case of a Roth IRA the upfront taxation.
Notice no mention of “capital gains”? IRAs are not considered to have taxable capital gains. Although trades inside of an IRA can produce gains or losses, as long as these transactions remain inside of the account, they are not subject to capital gains taxation.
In fact, you are only taxed on those assets either when you withdraw funds early from an IRA, take distributions from a regular IRA, or when you contribute to a Roth IRA. Those taxes are assessed at ordinary income rates.
If you are already thinking of opening a Precious Metals IRA, know that you can do so without needing to worry about paying any sort of capital gains tax.
This background on capital gains taxes is presented for your educational purposes only—to help give you a better sense of what to expect from your retirement savings and your taxes, and how to wrap your head around a lot of the financial jargon that’s out there. In no way does it constitute advice; for advice tailored to your particular situation, it is recommended that you speak with a certified financial professional directly.