Most of us are familiar with the taxes that we pay on the money earned through our jobs – ordinary income such as wages, salaries and commissions. Normally, the tax amount that we owe is calculated and withheld by our employer and sent to the Federal government, and usually the state and local government as well, without us having to worry about it.
But what about when you earn money simply by selling something that you own – such as property, stocks, mutual funds, bonds and other capital assets that are not in a tax-deferred account such as an IRA – that has increased in value since you purchased it? These increases in value are called capital gains. Generally, for most taxpayers, the tax rate on capital gains is much lower than on ordinary income. Fortunately, the taxes on capital gains are normally easy to calculate, and with knowledge of how capital gains tax rates work, you can save a significant amount on your tax bill.
Short-Term vs. Long-Term
The most important consideration when determining your capital gains tax rate is whether it is a “short-term” gain or a “long-term” gain. The difference? A day. Short-term gains are the profits you made from selling an asset that you owned for one year or less, and long-term gains are profits you made from selling an asset that you owned for a year and a day or more. The amount of time for which you owned the asset is known as the “holding period” and it’s why proper recordkeeping is crucial. Additionally, knowing the holding period for your assets helps you plan when to sell, and since there is such a small difference between short-term and long-term gains, waiting to sell until the holding period is more than a year can mean a rather large savings in taxes.
Taxes on Short-Term Gains
The tax rate for short-term gains – with the exception of a few special circumstances that we will discuss below – is your marginal tax rate, meaning that is the same as the rate that you would pay on income. Unfortunately, if you have a short-term gain, the tax treatment that you receive will be no more favorable than if the money had come from wages. For this reason, most investors choose to hold their investments long enough to qualify them for the long-term gains rates.
Determining the Tax Rate on Long-Term Gains
If you have a long-term gain, congratulations! You’re now able to claim one of the lowest tax rates on any kind of income available under the current tax code. Long-term gains are taxed at either 15% or nothing, depending on which tax bracket you fall into for that year.
What’s Your Tax Bracket?
To determine the tax rate of your long-term capital gain, you must first figure out which tax bracket you will end up in for the year. The amount of income that you can earn before having to pay capital gains taxes depends on how you file your taxes. (Note that your income level includes the income earned from your capital gains, as well as any other income that you earned or received during that year.) If you file as single, you can make up to $34,500 (for 2011) before paying capital gains taxes. If filing as married filing jointly or as a qualified widower, you can make up to $69,000 (for 2011), and if filing as married filing separately, you can make up to $34,500. Those filing as head of household can make up to $46,250 without paying capital gains taxes on long-term gains.
If your total income (which, again, includes the capital gain itself as well as all other income) exceeds those amounts then your tax rate on the capital gain is 15% of the gain.
Just Over the Line?
Keep in mind that if your income without the capital gains is less than the above amount that applies to you, and adding the capital gains puts your total income amount over the line, then you will only pay the 15% rate on the amount of capital gains that is over the line. For example, if you are single and your other income totals $31,000, but you have $5,000 in capital gains, your total income is $36,000, which means that you have to pay the 15% rate. However, you only have to pay the 15% rate on the amount above the maximum – so you will end up paying 15% tax on $1,500 in capital gains, as opposed to $5,000.
Notable Exceptions to the Rules
As with all IRS regulations, there are several circumstances under which special rules apply. The most common situations that cause people to run into tax problems are profits on primary residences, profits on collectibles, and dividends.
Profit on a Primary Residence
If your primary residence has increased in value, you may be looking forward to booking a tidy profit when you sell, and as long as you meet certain restrictions, you will not owe capital gains taxes on that profit. In order to qualify for this tax break, you must have lived in the home for at least 24 months out of the previous five years. However, if you must sell your home because of a job relocation or due to health problems, you may still qualify even if you have not lived there that long.
If you are single, you can take in up to a $250,000 profit tax-free from the sale of your home, and if you are married, you can pocket up to $500,000 tax-free in profit. Any amount of profit that you make in excess of those points is treated as a capital gain.
Profit on Collectibles and Precious Metals
This is another reason that collecting Precious Moments figurines might not beat the stock market. Regardless of how long or short of a time you have owned an item, the profit on collectibles that you own for investment purposes is taxed at 28%. If you fall within the 33% or 35% tax bracket, a short-term gain, this actually helps you out a little bit since 28% is the maximum.
Also, for those of us who like to invest in gold and other precious metals as a hedge against the stock market (or inflation, depending on how you look at it), whether it’s in coins or Exchange Traded Funds (ETFs), the IRS considers these to be collectibles as well. (Note that closed-end precious metal funds are not ETFs but are taxed as capital gains). So even though your gold ETF is managed like a stock, it is taxed like a Beanie Baby.
Many people slip up when reporting dividends because they assume that since they’ve owned the stock for years, they can report all the dividends as a long-term gain. However, that is not the case. Ordinary dividends are taxed as ordinary income and therefore do not qualify for special long-term gain tax rates. However, qualified dividends can be taxed at long-term rates and will be separated out for you on your 1099-DIV.