When you sell an investment and make money, your profit may be taxed, just like other kinds of income. Taxpayers collectively log hundreds of millions of transactions each year involving so-called capital gains and losses, according to IRS statistics.
So it's important to understand what capital gains are, and how they can affect your tax obligations.
When you sell a taxable investment such as stocks, bonds, collectibles, or a home, your profit is called your "capital gains." It's calculated based on the difference between the asset's value on the purchase date and what it's worth on the date you sell. (If the investment's value has decline between those dates, that's a capital loss. More below on how those can help reduce your tax bill.)
The federal government and most states levy taxes on capital gains. The tax rate depends in part on how long you held the investment.
"Short-term gains just get added on to all of your other income," says Naomi Ganoe, CFP, managing director and private client services practice leader at tax consulting firm CBIZ MHM.
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Your capital gains tax obligations can also vary depending on the kind of asset and how you acquired it. For example, profits from selling collectibles like coins and art have a higher maximum tax rate, while homeowners who sell their primary residence and meet certain qualifications can exclude up to $250,000 in capital gains ($500,000 for a married couple filing jointly).
And if you inherited the asset, it's typically considered a long-term holding, although special rules apply to calculating your profit or loss.
There can be some surprises. Even if you haven't been trading stocks, you may receive a 1099 for capital gains from mutual funds in your taxable brokerage account. "Funds sell underlying investments and the gain is reported to the taxpayer, who then pays tax on it," says Ganoe. "The taxpayer still owns the fund."
You may have capital gains to report without a 1099 in hand. Cryptocurrency, such as Bitcoin, is subject to capital gains, but most cryptocurrency companies don't send 1099s, says Jeffrey Zufall, senior tax advisor and investment advisor representative at Capital Advisory Group.
"Last year was the first year the IRS asked whether a person has participated in cryptocurrency," Zufall says, noting that the question appeared on federal tax return forms. "I think that's the precursor to say, 'Hey, you guys, you need to start reporting this.'"
With that in mind, it's smart to keep track of your cost basis, or the asset's value at the time you acquired it, as well as any sales you make.
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With planning, you may be able to employ strategies to limit your capital gains tax obligations.
One key strategy: Sell some losing investments, a strategy called tax loss harvesting. (You'll need to be careful about how you implement this strategy to avoid potential pitfalls, including shifting your portfolio diversification or running afoul of so-called wash-sale rules.)
That can help investors use capital losses to offset capital gains at tax time. If you had say, $1,000 in gains and $1,000 in losses, those would cancel each other out. And if you have more losses than gains, you can claim up to $3,000 worth of those additional losses as a deduction against your regular wages, Zufall says. Any remainder can be rolled forward to claim in the next tax year.
You can also save money on your capital gains taxes by holding on to an asset until it qualifies as long term.
At the same time, you don't want the taxes to govern your choices about selling an investment, says Ganoe.
"We always say, 'Don't let the tax wag all the decisions,'" she says. "If [an investment] is losing money, obviously, you've got to look at potentially selling it. But if it's making money, the tax can't be the only determining factor in holding or selling an asset."
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