Capital Gains Taxes Explained: Invest More Tax-Efficiently

When deciding whether or not an investment is worth it, you probably look at the cost versus the projected return on investment. However, there's a huge factor that you might be forgetting about, and doing so can be a deciding factor in whether or not you're making a good investment: capital gains taxes.

While capital gains tax rates are fairly straightforward, understanding when and how they apply can be tricky. This is especially true if you invest outside of stocks and bonds and don't know how alternative assets are taxed. Here's everything you need to know about the capital gains tax and how to maximize the tax efficiency of your investments.

The capital gains tax is a tax on the profits you make from the sale of an investment. This can be anything from stocks to real estate to gold, although there are some exceptions for certain alternative assets as explained below. A capital gains tax applies only to assets that are held for more than one year.

A common misconception is that your investments are taxed as they grow. In other words, if you made $500 on your stock market investments this tax year, you might think that $500 will be taxed. However, the capital gains tax is assessed on profit from the sale of an asset—called "realized gains"—so you're taxed only once you sell those stocks. In other words, if you didn't sell any of your investments in that tax year, your gains are considered "unrealized capital gains" and you don't have to pay taxes on them.

Long-term capital gains vs short-term capital gains

The difference between long-term capital gains and short-term capital gains comes down to the holding period of your investment. If you hold an asset for more than one year, any gains or losses are considered long-term capital gains and taxed at the capital gains rate. If you sell an asset within one year or less of the purchase date, any gains or losses are considered short-term. Short-term capital gains are taxed as regular income.

In most cases, your tax rate will be lower on long-term capital gains than short-term capital gains because most people fall into a higher income tax bracket than their capital gains tax bracket. For example, if you make $120,000 a year, your capital gains tax rate for 2021 is 15% but your income tax rate is 24%. This is why it often makes sense to hold onto an asset for more than 365 days if you want to maximize the tax efficiency of your investments.

Capital gains tax rates generally range from 0% to 20% depending on your tax bracket. The tax is assessed as a percentage of your total realized capital gains, which are calculated by subtracting the original price of the asset (known as the asset's cost basis) from its final sale price. The formula for calculating the capital gains tax is as follows:

(Final sale price of the asset − Cost basis of the asset) × Your capital gains tax rate

Let's say you purchase stock in your favorite clothing brand for $100. Five years later, your shares are worth $150 and you decide to sell. You make $90,000 a year, which means your capital gains tax rate is 15% for 2021. Here's how you would calculate the tax on the sale of that investment.

($150 − $100) × 15% = $7.50

In reality, these calculations can get a lot more complicated, especially if you have a number of different investments. First of all, you can subtract any fees you pay on the sale of an asset from its final sale price. So if you're charged a trading fee when you sell those shares, you can subtract that from the $150 final sale price—although most roboapps nowadays offer commission-free trading.

On top of that, you're also allowed to add certain fees and other costs of acquiring an asset to your cost basis. If you bought $100 worth of stock and paid a $1 trading fee, your cost basis would be $101. There's a lot more that goes into determining cost basis though, especially when you're investing in alternative assets, and calculating this correctly could make a huge difference in your tax bill.

Calculating cost basis

Figuring out what you can and can't add to the cost basis of an investment is tricky and largely depends on the asset. It's crucial to maximizing your returns, however, because the higher your cost basis, the lower your gains—and the lower your tax bill. If your investments are complicated, it's probably worth hiring a tax professional, but here are some common adjustments made to the cost basis of different assets.

• Stocks: Commissions and fees for buying stocks are the most common costs that are incorporated into your cost basis. If you're earning dividends and you reinvest those, you'll still be taxed on those dividend earnings for the year you earned them. When you eventually sell your shares, you can add the cost of the additional shares you purchased with your dividends to the total cost basis. If you have $100 invested in a company and earn $10 in dividends that are reinvested, your cost basis rises to $110.
• Real estate: In addition to the actual price you paid for a property, you can also add some of the extra costs you incurred such as broker, attorney, and other settlement fees. You can often add the costs of any capital improvements you made to the property as well.
• Art and collectibles: There are a lot of costs associated with buying and owning art and collectibles that can often be added to the cost basis when the sale of one of these assets triggers a capital gains tax. These can include auction and broker fees, restoration fees, appraisal fees, and transportation costs. If you inherited the asset rather than purchased it, your cost basis will be its market value at the time of acquisition.

Source: https://www.irs.gov/

The table above shows your long-term capital gains tax rate according to income. As you'll see below, there are some exceptions to this rule. The majority of investors will fall under the 15% capital gains tax bracket, which is lower than most people's income tax rate—this is why you'll generally pay a higher tax rate on assets you hold for less than a year.

As with nearly everything when it comes to taxes, there are exceptions to the rule. Here are a few common ones.

Real estate

Within real estate, your primary residence presents an exemption to the capital gains tax in many cases. When you sell a qualifying primary residence, you don't have to pay capital gains tax on the first $250,000 of gains for single filers and $500,000 for married filers. This rule does include many caveats—for example, you can only use it once every two years, and you have to have owned the home and used it as your primary residence for at least two years.

If you sell an investment property, there's also a workaround to the capital gains tax on the sale of a property called a 1031 exchange. Essentially, this rule allows you to avoid capital gains taxes if you sell an investment property and reinvest the profits in another similar, qualifying property within a certain time frame. The property you buy must cost at least as much as the proceeds you received from the sale of the first property. In the end, you'll end up paying taxes when you sell the new property, so this is more like deferring your capital gains tax rather than avoiding it altogether.

Fine art and collectibles

Fine art and other collectibles (sports cards, precious metals, wine, and antiques, for example) are taxed at a higher capital gains rate of 28% regardless of your income. What's more, you can only deduct professional expenses from your gains if you're considered an investor. If you're considered a collector (if you display the art in your home, for example), you can't deduct any losses.

Cryptocurrency

This isn't an exception so much as an inclusion many people might not expect. You might expect cryptocurrency to be taxed as income considering it's spent like currency. However, people invest in cryptocurrency like an asset. So for tax purposes, cryptocurrency is considered a capital asset and thus the returns you earn are usually taxed as capital gains.