Understanding capital gains taxation is critical to success in financial planning. In its most basic form, capital gains tax is straightforward: where there is monetary gain realized, a tax is due. I think one of the more confusing concepts in the capital gains tax is understanding what events trigger a capital gains tax. A gain, in and of itself, in an investment does not necessarily mean the gain is realized. A transaction must take place for a capital gain taxable event to occur; positions in an investment must be sold or income must be received. In essence, if the investor has been given the chance to receive and make decisions about a gain, then the gain will likely be subject to capital gains taxation.
Let’s look further into what realization means. Investment income is a great case of realized taxable gain. Income generated by an investment is almost always subject to capital gains taxation (except for tax-free income, e.g. municipal bonds, etc.), even if that income is automatically reinvested; the investor has a chance to receive and use the income, in which case, he or she simply chose to reinvest the income into the original investment. The main component to understanding realization is that the investor had the opportunity to take the money, proceeds, or income to spend, reinvest, etc. If the investor can obtain the proceeds, then the gain is realized. If the investment is still invested and has not had the opportunity to be distributed, then it is not realized.
Let’s say, for example, I buy a share of stock in ABC, and as long as I hold onto that share, no matter what happens to the stock price, no gain is realized. If the stock price is purchased at $100, and it grows to $150, if I still own that stock, no gain is realized; therefore, no capital gain taxation event has occurred. If I then decided to sell that share of ABC for $150, I would realize a $50 gain, and I would pay taxes on that gain. (The gain is realized because the positions were sold and had the possibility of being distributed to the investor, even if the proceeds were reinvested.) I would receive a 1099R at the beginning of the following year to file with my personal tax return, and that realization of the $50 gain would be included in my tax return for the year in which it was realized.
There are two different types of capital gains tax: long-term and short-term capital gains.
Long-term capital gains tax treatment receives a tax break on the gain because the return or growth in the investment is not immediately realized, so there is a lower tax rate applied. Under current law, the tax rate for long-term capital gains tax falls between zero and 20%, depending on an individual‘s tax bracket. Additionally, for those in the higher income tax brackets there is an additional tax on investment income of 3.8% on top of the capital gains tax. (This tax is called the Net Investment Income Tax or NIIT.) The NIIT will then add to the impact of the capital gains tax, although it is not considered capital gains taxation.
Short-term capital gains tax, on the other hand, is taxed as ordinary income. The taxation on short term capital gains is taxed at the highest tax bracket of that person‘s income tax rate. If someone is in the 32% marginal tax bracket, then the taxation on their short-term capital gains is 32%.
What differentiates long-term capital gains versus short-term capital gains tax treatment is the amount of time that an investment is held before the investment gain is realized. If an investment is owned for one year or less, any gain is subject to short term capital gains. If an investment is owned longer than a year and subsequently sold, then the gain would be subject to long-term capital gains taxation.
What assets are involved in capital gains taxation? Virtually all non-depreciable assets are involved. Stocks bonds, mutual funds, ETFs, closely help businesses, real estate, collectibles, commodities, savings accounts, etc. Capital gains tax is calculated by subtracting the gain of an asset from the cost basis of the asset. Cost basis is the amount of money that was paid to purchase that asset, plus possible maintenance of maintaining the asset. Sales tax, delivery, maintenance to get equipment installed and running, and reinvestment are some of the items that add to cost basis.
Based on my prior example of purchasing a share of ABC stock for $100, if there was a brokerage fee of $5 associated with purchasing that share, then my cost basis is $105. If I sold the share of ABC for $150 and there was another $5 charge to sell the share, that charge would be deducted from my taxable gain. Without transaction costs, my taxable gain would appear to be $50. The transaction costs would both increase my basis and reduce my gain and make my taxable gain $40 instead of $50. So how long I own the ABC stock without selling it would determine my capital gains tax rate.
If I were in the 32% income tax bracket, and I owned that share of ABC stock for six months, then I would owe 32% on my $40 taxable gain, or $12.80. If I owned that share of ABC stock for more than a year before selling it, I would owe about 15% of the $40 taxable game, or $6. That’s a huge difference! Now $12 of tax versus $6 of tax doesn’t seem like a huge difference, but if the transactions were bigger, it would be a huge difference! Say I bought 1,000 shares of ABC for $100 and sold them for $150 six months later. That leads to a $50,000 gain, which would result in $16,000 of short-term capital gains tax at a 32% tax bracket, vs. $7,500 of 15% long-term capital gains tax if the shares were held for longer than one year!
When navigating this tax, there are oftentimes ways to reduce the impact of capital gains tax. Not every investment results in a gain, so the ABC stock that was purchased for $100 could have declined in value to $75. If that were the case, I would have a capital loss of $25, and the capital loss could be a short-term capital loss for a long-term capital loss, which could ultimately reduce the impact of capital gains taxes on other assets, on a dollar-for-dollar basis for the year in which the capital loss was recognized.
In a brokerage account with multiple securities and investment holdings mingled together, it is entirely possible that long-term capital gains and losses and short-term capital gains and losses all coexist. The short-term capital losses will offset the short-term capital gains, and the long-term capital losses will offset the long-term capital gains. Once those gains are offset and calculated, if there is an overall capital loss of either short-term or long-term loss, then that loss can be deducted from any other capital gains in the account or even capital gains from other assets, such as a profit from a real estate transaction.
Oftentimes in an investment account, an investment manager will intentionally take some losses on a position or two to reduce the tax burden for the rest of the investment portfolio. This strategy is referred to as tax loss harvesting. If there is a greater loss than gain for capital gains taxation purposes, that loss can be carried forward for future years up to $3,000 per year indefinitely, until the amount carried forward is exhausted.
One item to consider is that capital losses cannot be used to offset any income other than capital gains income. If I purchased ABC stock, and subsequently sold it for a loss, I could not deduct the loss against my earned income; I could only deduct the capital loss against capital gains. It is important to note that a loss in an investment portfolio cannot provide tax relief for earned income tax.
Understanding capital gains taxation is a critical component in financial planning, whether you’re a do-it-yourselfer, you rely on a trusted team of advisors, or somewhere in between. As we make decisions about our assets, it is important to have a baseline knowledge of how the rules behind buying and selling our assets work. In the world today, with the gamification of the stock market and the easy access of buying and selling securities through phone applications, I would imagine there is a significant misunderstanding of capital gains taxation. Understanding capital gains tax treatment can mean the difference of realizing a gain and keeping a gain.