Artifacts Images/Digital Vision/Getty Images

Introduction to How Capital Gains Tax Works

That darn Internal Revenue Service. They want a cut of every little penny we earn. Income taxes are one thing, but the IRS also wants a percentage of any money we make from the sale of stocks, real estate and other capital assets. That’s where the dreaded capital gains tax comes in.
Let’s start with some definitions. What exactly is a capital gain? A capital gain is when the sale price of an asset is higher than the initial purchase price. Let’s say you buy a diamondring for $5,000 and sell it a year later for $6,000. The amount of capital gain is $1,000. There’s also such a thing as a capital loss, when the selling price of an asset is less than the original purchase price. But we’ll talk more about that later.
The capital gains tax takes a percentage of all realized capital gains. This is an important distinction. A capital gain is said to be "realized" when the asset is sold. An unrealized capital gain is an asset that has increased in value, but has not been sold. The IRS can only tax you on capital gains that you’ve sold and collected. Take that, tax man!
For example, let’s say you buy some stock in Google, and over the course of a year the stock goes up by $100. If you hold onto the stock, the IRS can’t tax you for that $100. But if you sell the stock and collect your $100 profit, then that’s a realized capital gain and is therefore taxable.
But what kinds of assets are taxable exactly? Do I have to tell the IRS if I make $5 selling an old Bee Gees record at a garage sale? And does everybody get charged the same rate for capital gains tax? How is it calculated? Read on to find out more.
1



If you sell your house and make a profit from the sale, that qualifies as a capital gain.
Stockbyte/Getty Images

Taxable Gains

The IRS defines a capital asset as "almost everything you own and use for personal or investment purposes" [source: IRS]. That's a lot of stuff. So technically, yes, you'd have to tell the IRS about that Bee Gees record. But the most common taxable assets are securities, real estate and valuable collectibles.
Securities are any kind of financial instrument or investment contract that has value. Examples are stocks, bonds and options. Once again, it's important to understand that you'll only be taxed on securities that you've sold in the past year. If your stocks go up during the year, but you hold on to them, you won't be charged a capital gains tax. Other types of investment income that fall into the capital gains category include annual dividends received from certain types of mutual funds and real estate investment trusts (REITs).
If you use a broker to help buy and sell stocks and bonds, then the brokerage firm will send you a form at the beginning of the year called a "1099-B, Proceeds From Broker and Barter Exchange Transactions," which lists all of your earnings and losses from the sale of securities. It's typical for the brokerage firm to list the earnings as net proceeds, meaning how much you earned minus any associated commissions and fees. If they list gross proceeds, then you'll have to deduct the commissions and fees yourself [source: CCH].
If you sell real estate or property, either for personal or business purposes, and make a profit from the sale, then that qualifies as a capital gain. Different tax rates apply to sales of personal and business property. Thanks to the Taxpayer Relief Act of 1997, however, there are some significant tax breaks when you sell your primary residence.
According to the 1997 law, if you've used a home (or apartment, or trailer or even houseboat) as your primary residence for at least two out of the last five years, you can exclude up to $500,000 in capital gains from the sale of that property [source: Investopedia]. The $500,000 exclusion is only for married couples who file jointly. Individual filers can exclude up to $250,000. That means you don't have to pay taxes on money made from selling a primary residence unless the earnings exceed $250,000 or $500,000, depending on your filing status.
Sales of art, rugs, antiques, jewelry, precious metals, wine, stamps, coins and other valuable collectibles are indeed taxable as capital gains. We'll talk more about capital gains tax rates and how to calculate them in the next section.

Calculating your capital gains taxes can get tricky.
Ryan McVay/Digital Vision/Getty Images

Calculating Capital Gains

The first step is calculate exactly how much capital gain you've earned in the last year (yes, you must pay capital gains tax every year). This sounds easy enough. All you have to do is take the sale price of a capital asset (stock, real estate, etc.) and subtract the original purchase price. But it gets a little trickier if you're not the person who originally purchased the asset or investment.
The original purchase price of an investment (like stock, other securities or investment property) is known as the cost basis. There are several different ways to calculate this:
  • If you purchased the investment, then the cost basis is the price you paid for it.
  • If you inherited the investment, then the cost basis is the value of the investment on the date that the original owner died.
  • If you received the investment as a gift, then the cost basis is the original price of the asset, unless the investment was worth less than that amount when it was given to you. [source: InvestorGuide].
Once you've figured out how much you've earned from the sale of each asset, you need to figure out how long you've owned each asset. This is called the holding period of an investment and is divided into three categories, each with a different tax rate:
  • Short-term investments are those that are sold less than a year after they were purchased.
  • Long-term investments are held for a least a year before being sold.
  • Super-long-term investments must be held for over five years after the original purchase. This category is only good for investments purchased after January 1, 2001 [source: Investopedia].
The IRS favors long-term investments over short-term. So the capital gains tax rates for short-term investments are almost always going to be higher than for long-term investments. The specific rates for each holding period depend on what type of asset was sold.
But the most important factor that determines your capital gains tax rate is your income tax bracket. The higher your income tax bracket, the more you're going to pay in capital gains tax. As a general rule, you pay capital gains tax at the same rate as income tax for all short-term investments. So if you're in the 10 percent income tax bracket, you'll pay 10 percent for all short-term capital gains. And if you're in the 35 percent income tax bracket, you'll pay 35 percent for all short-term capital gains.
When filing in 2008, taxpayers in the 15 percent income tax bracket or lower will pay 5 percent on long-term capital gains. Everyone else will pay a flat rate of 15 percent. Starting in the 2008 tax year, long-term rates are dropping to zero percent for taxpayers in the 15 percent income tax bracket or lower.
There are some exceptions for long-term capital gains rates. The long-term rate for collectibles is currently a flat 28 percent across all tax brackets. That's the same for small business stock held for more than five years. For real estate sales, the long-term capital gains tax is either 5 percent or 15 percent after any primary residence exclusions.
Capital gains earnings, losses and taxes owed are recorded in Schedule D: Capital Gains and Losses of the United States tax return.
Now let's look at a few of the most effective ways to lower your capital gains tax burden.

One of the best ways to lower your capital gains taxes is to sock money away in a 401(k).
Don Farrall/Photodisc/Getty Images

Lowering Your Capital Gains Tax

The simplest strategy for lowering the amount you owe in capital gains tax is to avoid short-term investments. Long-term investments will almost always have a lower tax rate than short-term investments. In the case of the lowest tax brackets, you'll pay nothing for long-term capital gains on most securities.
Capital gains tax should always be considered when making an investment in stocks or other securities. It might seem smart to make a short-term investment with a higher interest rate than a long-term investment with a lower rate. But after capital gains tax is collected, that long-term investment might leave more profit in your pocket.
Another strategy for avoiding high capital gains taxes is to shelter as much income as possible in tax-deferred retirement accounts like 401(k)s, Roth IRAs and Traditional IRAs. The cool thing about these accounts is that you can buy, sell and exchange securities within the account without being charged any capital gains tax. These accounts shelter your investments from capital gains tax as long as any money earned from a sale is reinvested in another security.
When you begin to withdraw money from a retirement account -- after you've reached retirement age -- you'll be taxed at your normal income tax bracket. The advantage here is that when you're retired, you'll probably be in a lower tax bracket than when you were working [source: Investopedia].
The final strategy for lowering your capital gains tax burden involves those capital losses we mentioned before. If you sell an asset for less than its original purchase price, that's a capital loss. You can subtract, or deduct, capital losses from your capital gains to lower your total taxable earnings. A smart strategy is to sell any investments that are losing money within the first year. That way you won't have to pay a high, short-term capital gains tax if they somehow start to earn money.
Interestingly, unlike capital gains, you don't have to apply capital losses to the tax year in which they occurred. It's legal to carry over losses from the current year to one of the next seven years of tax returns. This way you can wait for an especially high capital gains year to use the capital loss deduction.
For more information on investing and personal finances, take a look at the links on the next page.

Lots More Information

Related HowStuffWorks Articles

More Great Links

Sources
  • Internal Revenue Service. "Capital Gains and Losses"http://www.irs.gov/taxtopics/tc409.html
  • Investopedia. "A Long-Term Mindset Meets the Dreaded Capital Gains Tax"http://www.investopedia.com/articles/00/102300.asp
  • InvestorGuide. "Tax Basics: Explanation of the Capital Gains Tax and Related Issues" http://www.investorguide.com/igu-article-855-tax-basics-explanation-of-the-capital-gains-tax-and-related-issues.html
  • Lambert, George D. Investopedia. "Seek Out Past Losses to Uncover Future Gains" http://www.investopedia.com/articles/mutualfund/06/carryforwards.asp
  • Lambert, George D. Investopedia. "Will Your Home Sale Leave You with Tax Shock?" http://www.investopedia.com/articles/pf/06/homesaletax.asp
  • Tax Learning Center from CCH. "Capital Gains Tax Rate" http://fidelity.cch.com/c60s10d459.asp
  • Tax Learning Center from CCH. "Computing Capital Gains" http://fidelity.cch.com/c60s10d462.asp
  • Tax Learning Center from CCH. "What is the Basis?" http://fidelity.cch.com/c60s10d474.asp