What is Capital Gains Tax?

Capital gains tax applies to the sale of capital assets like equity, bond, collectibles, and real estate.¹ The capital gain is the difference between the purchase price and the selling price, and that portion is where capital gains tax is levied.

How Capital Gains Tax is Calculated

In the US, the capital gains tax rate is determined based on the length of time that the asset has been held. A higher rate is applied if the asset is held for less than one year (short-term capital gains). Taxable income, including the capital gain, also determines the tax rate applied to the realized profits.

For real estate, the capital gain is calculated after accounting for inflation based on an inflation index. There are exemptions if the profit is within a certain amount or if the proceeds are used to purchase another residential property. The rate of tax can be higher for items like collectibles. If a loss is realized on the sale, the loss can reduce overall gains from other assets and offset the taxable income.

How to Minimize or Avoid Capital Gains Tax

Investors can help reduce the capital gains tax by holding an asset for more than a year. Gifting the asset to a relative can help reduce tax liability as well. In addition, investors may take advantage of tax-loss harvesting, a practice in which one sells assets at a loss to offset capital gains taxes.²

Example

Berk and Hatha are a couple who have sold their residential property for a gain of $800,000. If the tax-exempt amount for calculating profit is $500,000, they would have to pay capital gains tax for the remaining $300,000. However, if the couple decides to purchase a new residential property using the sale proceeds, the profit can be tax-exempt.

References

1. “Capital Gains Tax.” Investopedia. https://www.investopedia.com/terms/c/capital_gains_tax.asp
2. “Tax-loss harvesting.” Investopedia. https://www.investopedia.com/terms/t/taxgainlossharvesting.asp

Alpaca does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Investments in securities involve the risk of losses and past performance does not guarantee future results. Before investing you should carefully consider your investment objectives, time horizon, and overall risk tolerance as well as the information stated in the product offering prospectuses.