When investing in stocks, real estate, or other appreciating assets, being aware of the capital gains tax rate can have major implications for your after-tax returns. Capital gains tax rates on long-term investments range from 0% to 20% depending on your income. These rates are far lower than the ordinary income tax rates, which top out at 37%.
Understanding how capital gains are taxed, the different rates, and strategies to minimize your tax liability can help you manage investments in a more tax-efficient manner. This guide will explain everything you need to know, with examples demonstrating how capital gains offer preferential tax treatment compared to ordinary income.
What are Capital Gains Taxes?
A capital gain occurs when you sell an investment asset like stocks, bonds, mutual funds, or real estate for more than your purchase price. The profit or gain that you make from the appreciated asset is subject to capital gains taxes rather than ordinary income taxes.
For example, if you buy a stock for $100 per share and later sell it for $150 per share, your $50 per share capital gain would be subject to capital gains tax rates on the profit. The same concept applies to selling a home or other assets for more than the original cost.
Capital losses on assets can be used to offset capital gains, lowering your overall tax liability. Deducting capital losses against regular income is limited to just $3,000 per year, with unused losses carrying forward.
The capital gains tax rate you pay depends on two factors:
Your total taxable income
How long you held the asset before selling
We’ll dig into these in more detail throughout this article.
Key Benefits of Capital Gains Tax Rates
Compared to ordinary income tax rates, capital gains offer two major advantages:
Lower rates - Maximum long-term capital gains rates can be up to 20% lower than the top marginal income tax bracket.
Tax-free appreciation - No taxes are due on the increasing value of assets until sold. You benefit from tax-deferred growth over time.
Being able to earn investment profits taxed at lower capital gains rates rather than ordinary income rates allows you to keep more of your returns and maximize after-tax income.
Capits vs. Ordinary Income Tax Exampleal Gain
To illustrate the potential tax savings, let’s compare a hypothetical $50,000 long-term capital gain to $50,000 of ordinary employment income:
Ordinary income of $50,000 is taxed at 32%, amounting to $16,000 owed.
A long-term capital gain of $50,000 is taxed at the 15% capital gains rate, amounting to $7,500 owed.
All else being equal, the capital gain results in $8,500 of tax savings compared to if it had been taxed as ordinary income. The benefit of capital gains compounds on larger investment profits or for higher-income individuals in higher brackets.
Now let’s examine the specific capital gains rates based on your taxable income and holding period.
Capital Gains Rates Based on Taxable Income
For both long-term and short-term capital gains, the rate you pay correlates to your total taxable income including all sources such as wages, self-employment income, dividends, interest, etc.
The income thresholds used to determine capital gains rates are adjusted annually for inflation. Here are the rates for 2023 based on taxable income:
Long-Term Capital Gains Rate (held >1 year)
0% - $0 to $44,625 income (married filing jointly)
15% - $44,626 to $517,200
20% - Over $517,200
Short-Term Capital Gains Rate (held 1 year or less)
10% - $0 to $11,000
12% - $11,001 to $44,625
22% - $44,626 to $517,200
24% - Over $517,200
As you can see, long-term capital gains rates are significantly lower. Holding assets longer term allows you to qualify for the preferential 0%, 15%, or 20% rates versus short-term rates aligned with ordinary income brackets.
Capital Gains Rates Based on Holding Period
In addition to your income determining the capital gains rate, the length of time you hold an asset also plays a key role:
Long-Term Capital Gains - Assets held over 1 year before selling are subject to the long-term capital gains rates outlined above.
Short-Term Capital Gains - Assets held 1 year or less before selling are subject to the higher short-term capital gains rates equivalent to ordinary income brackets.
The holding period requirement incentivizes longer-term investing.
For example, say you purchased shares of stock for $10,000 two years ago. The shares are now worth $18,000. If you sold them today, the $8,000 capital gain would qualify for the lower long-term capital gains tax rates.
But if you had purchased the shares just 9 months ago, the $8,000 gain would be considered short-term and lose the preferential rates.
Tax Planning Strategies to Reduce Capital Gains
The capital gains tax applies when assets are sold. You have control over when you “realize” gains by selling appreciated assets.
Strategically timing when gains are realized allows you to minimize total taxes owed. Ways to reduce capital gains taxes include:
Harvesting tax losses by selling declining investments to offset capital gains
Avoiding selling in years with unusually high income or gain amounts
Staggering sale of assets across multiple years to stay below thresholds
Holding assets until death to receive a step-up in basis eliminating taxes
Using retirement accounts like IRAs or 401(k)s which defer taxes on gains
Donating appreciated assets to charity for income tax deductions
Moving to a state with no income tax which exempts capital gains
With proactive planning, you can time the realization of capital gains and losses to your advantage.
How Capital Gains Are Taxed at Death
A unique advantage of long-term capital gains is they can essentially avoid income tax altogether if the appreciated assets are held until death.
Upon death, the tax basis of capital assets owned by a deceased person are “stepped up” to their date of death value. This eliminates any embedded capital gains accrued during the person’s life.
For example, say you purchased shares of stock for $100,000 years ago that are now worth $500,000. If you sold them while alive, you would report a $400,000 capital gain.
But if you continue holding the shares until death, your heirs inherit the shares with a new cost basis of $500,000. If they immediately sold the shares, there would be no capital gain tax owed.
Stepped-up basis at death on long-term holdings provides a powerful capital gains reduction strategy.
How Capital Gains Are Taxed on Real Estate
In addition to stocks and funds, real estate investors also benefit from capital gains treatment on the sale of properties. However, real estate has some unique tax implications.
For capital gains on real estate, the holding period is measured from the settlement date when the deed transfers rather than the original purchase date.
Primary residences also receive a $500,000 capital gains tax exemption for couples or $250,000 exemption for singles if living in the home 2 of the past 5 years before selling.
Real estate investors may also face depreciation recapture taxes in addition to capital gains on property sales.
Capital vs. Ordinary Gains: Case Study Examples
To highlight when capital gains rates apply versus ordinary income tax rates, let’s examine some examples:
Example 1: Selling an investment property
John purchased a rental property for $200,000 that appreciates to $350,000 over 15 years. When he sells, the $150,000 gain is taxed at capital gains rates since it involved the sale of a real estate investment held long term.
Example 2: Selling a business
Jane purchased a small local clothing shop for $100,000 and sold it 2 years later for $250,000, netting a $150,000 profit. Since she held the business less than 1 year before selling, the gain is subject to ordinary income tax rates rather than capital gains.
Example 3: Stock options from an executive role
Mike had employee stock options as a corporate executive that he exercised after 2 years then immediately sold the same day. Since he held the shares less than 1 year before selling after exercise, the profit is considered ordinary income rather than a long-term capital gain.
Example 4: Selling an antique for more than purchased
Robert bought an antique car 25 years ago for $20,000 that he sold recently for $70,000. The $50,000 gain qualified for lower long-term capital gains rates since he owned the antique car for over 1 year.
As these examples demonstrate, the holding period and the type of asset are key determinants of whether capital gains vs. ordinary tax rates apply.
Common Questions on Capital Gains Taxes
Here are answers to some frequently asked questions on how capital gains are taxed:
Are capital losses deductible against ordinary income?
No, capital losses can only offset capital gains, with a limited $3,000 excess deduction allowed against other income annually. Unused capital losses carry forward to future tax years.
Are gains on cryptocurrency subject to capital gains tax?
Yes. Though cryptocurrency operates very differently from traditional assets, capital gains rules still apply to any appreciation when sold or exchanged for another coin.
Do wash sale rules apply to capital assets?
If you sell securities or cryptocurrency at a loss and repurchase the same or substantially identical assets within 30 days of the sale, the capital loss deduction gets disallowed under the IRS wash sale rule.
Are capital gains from selling a home taxable?
Capital gains on selling a primary residence are generally exempt up to $500,000 for married couples, provided the home was owned for 2 of the past 5 years. Gains above this are taxable.
Does capital gains tax apply to an LLC or partnership?
Capital gains realized by an LLC or partnership pass through to members or partners. The long-term or short-term holding period is measured at the entity level before being allocated individually.
Minimizing Tax Rates & Making the Most of Your Capital Gain in Practice
With the potential for significant tax savings, properly managing capital gains and losses should be an integral part of your overall investment strategy. The complex interplay between holding periods, taxable income, and asset types can make tax planning difficult. Discussing your capital gains situation with a specialist at United Tax can help you determine when to take gains and losses to your maximum advantage. Our experts can ensure you pay only what you legally owe by leveraging preferential capital gains rates and timing realizations strategically. Don't leave potential savings on the table. Contact United Tax today to discuss your capital gains tax planning.
