Capital Gains Tax: What It Is And How To Avoid It
UPDATED: Feb 5, 2024
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Selling your home for a profit may come with the promise of a big fat check. But if you are earning a profit on the sale of your home, then you might be facing capital gains tax. The possibility of paying taxes can take a bit of the wind out of your home sale sails.
Selling your home isn’t the only time you may have to worry about capital gains taxes. Any capital asset that you own for more than a year and sell for a profit may be subject to capital gains taxes. Luckily, there are some legal ways to avoid that unexpected cost.
What Is A Capital Gains Tax?
A capital gains tax is a tax on the profits from the sale of a capital asset. A capital asset is any property you own that has value. The property can be tangible (such as a house) or intangible (such as a stock in a company.) For example, you will need to pay capital gains on the profits if you sell your home that you’ve lived in for over a year for more than you bought it for.
This type of tax is different from an ordinary income tax that taxes income you receive from a job, rental income or interest income. However, ordinary income taxes can also apply to profits from the sale of a capital asset depending on how long you owned the asset.
One important thing to note about capital gains taxes is that you don’t owe them until you actually sell your investment. If your home steadily rises in value over the years, you don’t need to include this as appreciation on your income. The tax is only levied when you decide to sell. This can allow you to offset your capital gains with capital losses by selling your investments at strategic times.
Long- Vs. Short-Term Capital Gains
The difference between long-term and short-term capital gains is whether you owned an asset for more than a year before you sold it for a profit. The IRS considers profits from selling an asset that you owned for less than a year as short-term capital gains and taxes them as ordinary income. The IRS considers profits from selling an asset that you owned for more than a year as long-term capital gains and taxes them at the capital gains tax rate.
This system incentivizes investors to hold on to their assets for a longer period because long-term capital gains tax rates are usually much lower than short-term capital gains tax rates.
How Does Capital Gains Tax Work?
When you’re subject to the capital gains tax, you pay tax on a percentage of the profit you earned selling your asset. The percentage you pay depends on the type of asset you sold, your income, how long you owned the asset and how much money you made on the sale. We’ll go over how you can calculate your potential capital gains tax liability in later sections.
Keep in mind that you only need to pay capital gains taxes on excess income that you earned on the sale. You don’t need to pay the assigned tax rate on the entirety of your sale.
Let’s take a look at an example. Imagine that a decade ago, you bought a home for $250,000. But now, it’s time to move on. So, you put your home on the market and accept an offer for $350,000. In this example, you see a capital gain of $100,000 on your home sale. If your income and asset class put you in the 20% capital gains tax bracket, you pay 20% of your profit. That’s 20% of $100,000, or $20,000. You don’t need to pay 20% of the entire $350,000 sale because you had to spend $250,000 to buy the asset.
The opposite of a capital gain is a capital loss. A capital loss occurs when you sell a capital asset for less money than you bought it for. For example, if you sell the home you bought for $250,000 for $200,000, you saw a capital loss of $50,000.
It’s logical to assume that if you must pay capital gains taxes on the sale of your home, you can also deduct losses from your taxes. Unfortunately, capital losses from the sale of a personal property that you live in aren’t deductible. You can only deduct losses associated with properties that you bought as an investment or rental property.
Capital gains taxes have special laws that dictate how much you pay. One important thing to note about capital gains taxes is that you don’t owe them until you actually sell your investment. If your home steadily rises in value over the years, you don’t need to include this as appreciation on your income. The tax is only levied when you decide to sell. This can allow you to offset your capital gains with capital losses by selling your investments at strategic times.
How Much Is The Capital Gains Tax?
The capital gains tax is applied to sales of assets for profit. Your rate is based on your net income and how long you’ve held onto said assets. The rate for long-term capital gains is 0%, 15% or 20%, while short-term capital gains rates go by the regular income tax brackets, or 10% – 37%.
2023 Long-Term Capital Gains Tax Brackets
Below are the income levels that will determine your capital gains tax bracket for the 2023 tax year.
| Filing Status | Maximum 0% Tax Rate | Maximum 15% Tax Rate | Maximum 20% Tax Rate |
|---|---|---|---|
| Single | Up to $44,625 | $44,626 - $492,300 | $492,301 and above |
| Married filing jointly | Up to $89,250 | $89,251 - $553,850 | $553,851 and above |
| Married filing separately | Up to $44,625 | $44,626 - $276,900 | $276,901 and above |
| Head of household | Up to $59,750 | $59,751 - $523,050 | $523,051 and above |
| Trusts and estates | Up to $3,000 | $3,001 - $14,651 | $14,651 and above |
2024 Long-Term Capital Gains Tax Brackets
Below are the income levels that will determine your capital gains tax bracket for the 2024 tax year.
| Filing Status | Maximum 0% Tax Rate | Maximum 15% Tax Rate | Maximum 20% Tax Rate |
|---|---|---|---|
| Single | Up to $47,025 | $47,026 - $518,900 | $518,901 and above |
| Married filing jointly | Up to $94,050 | $94,051 - $583,750 | $583,751 and above |
| Married filing separately | Up to $47,025 | $47,026 - $291,850 | $291,851 and above |
| Head of household | Up to $63,000 | $63,001 - $551,350 | $551,351 and above |
| Trusts and estates | Up to $3,150 | $3,151 - $15,450 | $15,451 and above |
Don’t forget that these tax rates only apply to capital gains from assets that have been owned for more than a year. If you sell a capital asset that you owned for less than a year, the IRS considers it a short-term capital gain which is taxed as ordinary income based on the federal income tax brackets. That means instead of paying 0%, 15% or 20% on your capital gains, you could pay 10%, 12%, 22%, 24%, 32%, 35% or 37%, depending on your income level and filing status.
Calculating Your Capital Gains Tax On Sale Of Property
Your capital gains tax rate depends on the type of asset you sell, your income, how long you owned the asset and your profit on the sale. You don’t need to pay capital gains taxes on the entire sale price, just the sale price minus what you paid for the asset.
For example, let’s say that you’re single and earn $60,000 in income. You sell a property that you have owned for more than a year, so it is subject to the long-term capital gains tax. You bought the property for $100,000 and sold it for $150,000. That means you see a $50,000 capital gain. In the 2023 tax year, you would fall into the 15% tax category because your income is more than $47,026 but less than $518,900. In this example, you would pay 15% capital gains tax on $50,000, or $7,500. This tax is separate from the ordinary income tax you will pay on your $60,000 in income.
For another example, let’s keep all variables the same, except that instead of selling your property for $150,000, you are forced to sell it for $75,000. Instead of a capital gain, this is a capital loss of $25,000. While you may look for a tax break to offset these losses, you may be disappointed. If it is personal property that you live on, you can’t deduct the capital losses. You can only deduct capital losses from investment or rental properties.
How To Avoid Capital Gains Tax
There are several legal tactics that you can use to reduce or avoid capital gains taxes altogether.
Hold Onto Your Investments
Holding onto your investments for at least a year is the most straightforward way to avoid paying the highest possible tax rates. This strategy works by avoiding the expensive short-term capital gains tax. This is especially beneficial if you’re selling a personal property and want to take advantage of the principal residence exemption (more on that below).
If one of your capital assets is quickly declining in value, such as stock in a struggling business, you may feel the need to sell it before holding it for a year to cut your losses. However, in our next example you can find how even capital losses can help you save money on your taxes overall if you realize the losses after owning the asset for over a year to take advantage of the long-term capital gains tax rates.
Use Your Capital Losses
Investors can minimize their capital gains tax liability when they sell their assets after a period of loss. Depending on the type of capital asset you’re holding, you can often use your capital losses to “cancel out” any gain you saw earlier in the year.
For example, let’s say you have owned Stock A for 2 years. You bought Stock A when it was worth $4,000, but it has since decreased to $2,000 in value. If you don’t expect the stock value to rebound to its former glory, you can sell it to offset gains from another stock sale. Let’s say you bought Stock B 3 years ago for $3,000 and you sell it for $6,000. Instead of paying capital gains taxes on the full $3,000 profit, you can use your capital loss from Stock A to decrease your total tax liability.
This can be a risky move because in order to take advantage of this strategy, you have to lock in your losses from an underperforming stock. That is why it’s always wise to consult a tax professional before taking action.
Utilize Tax-Advantaged Discounts
There are several ways to take advantage of tax rules to decrease your capital gains taxes. One of the most popular strategies is to invest through tax-deferred retirement plans like IRAs or 401(k) plans. When you buy and sell investments through these plans, you don’t have to pay capital gains taxes. You only have to pay taxes when you withdraw from the accounts during retirement. This system helps you save money in two ways. By not taking out money for capital gains, your investment is allowed to grow more over time. Then, when you need to take out money during retirement, your income will probably be lower, putting you in a lower capital gains tax bracket and saving you even more money.
Exclude The Capital Gains Tax On A Home Sale
You’re exempt from a large amount of capital gains taxes when selling your principal residence based on your filing status. If you’re single, you’re exempt from capital gains tax on the first $250,000 of profit on your home. If you’re married filing jointly, you’re exempt from capital gains tax on the first $500,000 of profit on your home.
However, there are some key requirements to classify your property as your principal residence:
- You must have lived on the property for the last 2 out of 5 years.
- You must live there for the majority of the year.
- You must provide documented proof that you live there, such as a voter registration or tax return.
- The property must be reasonably close to your place of employment.
- If you’re married, your spouse must also claim the same property as their primary residence.
Sell When Your Income Is The Lowest
As we’ve gone over, the percentage you’ll pay on your long-term investments depends on your income. If your income is close to increasing above a limit that will put you into a higher capital gains tax bracket, It’s a good idea to sell your investments when your income is lower. If you’re self-employed or on a variable income, keep track of your revenue throughout the year and sell assets when your income is lower. You can also sell your assets after you retire.
Donate Your Appreciated Assets
Donating appreciated securities to charity can help you avoid both capital gains taxes and ordinary income taxes. If you donate a stock that you’ve owned for more than a year that has increased in value, you don’t have to pay any capital gains taxes on it. While it is a very kind thing to do, it may not appeal to many that can’t afford to give away growing investments. However, donating an appreciated security can also save you money on your ordinary income taxes because you can use it as an itemized deduction. That means you can decrease your taxable income by the fair market value of the stock.
The Bottom Line
If you’re planning to sell a property or other type of capital asset, you can take steps to dramatically reduce your capital gains. However, the tax code can get complicated. That’s why it is wise to speak with a tax professional or financial advisor if you’re considering taking advantage of strategies and tactics to reduce or avoid your capital gains tax liability.
Another way to help you save money is to sign up for the Rocket MoneySM app so you can take control of your finances today!
Patrick Russo
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