Almost any personal asset that you own has a cost associated with it. Typically, this is the amount you pay the cashier while they silently judge you for your obsession with mozzarella sticks. In the case of more durable objects, there is the potential that someone in the future might pay you more than your purchase price to take them off your hands, provided they weren’t put in the air fryer for six minutes.
The most common examples are stocks, bonds, and real estate, but can include goods ranging from cars to stamps. The amount you paid for the asset is the basis, which is typically static but can be adjusted by things like improvements or depreciation. When the asset is sold, you subtract the basis from the sale price to come up with the capital gain.
How that capital gain is taxed by the IRS is dependent on two things.
The first is how long you owned the asset in question. If you held it for a year or more, you’re going to pay long-term capital gains tax, which is a preferential rate. If you held it for a less than a year, you’re going to pay ordinary income tax, just like you would on any wages, pension, or IRA income.
The second factor is your adjusted gross income, and to explain how that works we need to briefly explain how tax brackets work. Tax brackets are kind of like a row of buckets. Any income you receive in a year goes into the buckets in order; first the 10% bucket, then the 12% bucket, and so on. You have to fill up each bucket before income “spills over” into the next one. You pay the 10% rate on the amount in the 10% bucket, and pay the 12% rate only on the income in the 12% bucket. In no case does earning extra income cause all of your income to be taxed at a higher rate.
That’s important to understand because long-term capital gains operate the same way, there are just fewer, bigger, and more generous buckets. There are seven different ordinary income tax brackets ranging from 10% to 37%. Meanwhile there are only three different long-term capital gains brackets: 0%, 15%, and 20%. These brackets are all dependent on whether you file singly, jointly, or head of household. Long term capital gains layer on top of your ordinary income, which works to the taxpayer’s advantage because it means that the more “expensive” ordinary brackets are filled first and the more generous capital gains brackets are used afterwards.
However, lurking beneath all of these taxes, there is a separate, slumbering, serpentine rate that dwells in section 1411 of the internal revenue code. Called net investment income tax by the American federal government, it requires that anyone with a MAGI (modified adjusted gross) of $200,000 (single) or $250,000 (joint) pay a 3.8% additional surtax on capital gains above that threshold. Most taxpayers are unaffected by this levy but it means that the theoretical maximum rate for long-term gains is 23.8%
Easy, right? Now that we’ve got the basics down, there are a few curveballs I need to throw in. The first is that there a few goods that are taxed at a higher rate. Collectibles, which includes coins, stamps, and your box full of baseball cards that Mom gave to Goodwill, have any capital gains taxed at a higher 28% rate.
On the other hand, personal residences benefit from significant capital gains tax exemptions. As long as you’ve lived in your home for at least two years you can exclude $250,000 in gain if single or $500,000 if married. Even if you haven’t lived there the full amount of time you can still receive a partial exemption.
Things also get more complicated with pooled investments like ETFs and mutual funds. With each of these funds you own a small piece of the investment pie, so to speak, and the managers that run it buy and sell assets to try to achieve their overall investment goals. It would be too cumbersome for individual investors to have to report each of these transactions on their own tax return, so the fund simply makes a “capital gains distribution”, usually in the latter half of the year, and the investor reports it as a long-term capital gain no matter how long they’ve held the fund.
One last thing, please remember that you only owe capital gains tax on a stock or bond when you sell it. If you bought one share of Amazon when it was $6 per share and held it all the way through, you would currently be sitting on almost $3,000 in unrealized capital gains, but still wouldn’t owe the IRS any money until you decided to cash in.
If you have a fortunate problem like that, feel free to tell us, we’d love to hear about it.
|2020 Long Term Capital Gains Tax Brackets
|$0 to $40,000
|$40,001 to $441,450
|Head of Household
|$0 to $53,600
|$53,601 to $469,050
|Married Filing Joint
|$0 to $80,000
|$80,001 to $496,600
|Married Filing Separately
|$0 to $40,000
|$40,001 to $248,300