What is a capital-gains tax?
Updated March 9, 2022
A capital-gains tax is a tax on the increase in value of investments and assets such as stocks, bonds, jewelry and real estate property when they are sold. Ordinary income such as wages and salaries are taxed on an annual basis, but capital-gains taxes are only levied when assets are sold and a profit is incurred.
When the assets are sold, the capital gains are said to be “realized.” Unsold assets such as stock shares that appreciate every year within a portfolio are referred to as “unrealized” capital gains. They do not incur capital-gains taxes until they are sold, no matter how long they have been held.
Capital-gains taxes vary depending on how long the investments were held. If they were held for less than one year, they are known as short-term capital gains and they are taxed as if they were ordinary income, just like wages and salaries. If the assets were held for more than one year before they were sold, they are known as long-term capital gains.
A capital-gains tax is a tax on the increase in value of investments and assets. Kelly Sikkema/Unsplash
The level of capital-gains tax that an investor pays depends on such factors as income level and the cost basis of the assets (how much the investor paid for them). In the U.S., capital gains are taxed at a 0%, 15% or 20% tax rate, depending on income level. Gains on collectibles such as jewelry, stamp and coin collections, precious metals, art and antiques are taxed at a flat 28% rate, regardless of income.
Along with capital gains, investors incur capital losses when they sell assets for less than they paid for them. By subtracting capital losses from capital gains, you come up with what is known as the “net capital gain,” and that’s what you pay capital-gains taxes on. Taxpayers can strategize within their investment portfolio to offset capital gains with capital losses to lower their capital-gains taxes.
In real estate, capital gains are taxed by the U.S. Internal Revenue Service using a different standard if you are selling your primary residence. For individuals, $250,000 of the capital gains on the sale of a home are excluded from taxable income as long as they have owned it for at least two years and have lived there for at least two years in the five-year period before they sell it; for those who are married filing jointly, it’s a $500,000 exclusion. For example, if an individual paid $400,000 for a home and later sold it for $700,000 that would mean a profit, or capital gain, of $300,000. After applying the $250,000 exemption, the taxpayer would report a capital gain of $50,000 on the sale.
For the most part, significant repairs and improvements to the property as well as assessments for the entire building can be added to the base cost of the home, thus reducing even more the amount of taxable capital gain.
To qualify as a capital improvement, it has to be something you’ve done to the home that adds value, something that you can’t take with you. A new bathroom or kitchen would qualify, while a new stove would not.
Owners of condos or co-ops can also factor in their contributions to permanent improvements in the building. Again, it has to be something like a new roof or heating system, not painting the lobby. Further, you can also take the closing costs from the original purchase of the home as a deduction. For all homeowners, it is important to keep good ongoing records of home improvements made over the years.
In general, the easiest way to reduce capital-gains taxes is simply to hold onto the asset or property for at least a year before you sell it, thus making it a long-term capital gain, which is taxed at a lower rate than short-term capital gains (assets held less than one year).
For information on property tax laws around the world, see Mansion Global’s Tax Talk column.