Selecting the right long-term investment can take up so much of someone’s time and effort that they totally forget to consider the tax implications of the various types of investments. This can lead to a heavy financial mistake because capital gains tax (CGT) can devour up to 37% of the profit generated by an investment. Below we examine how capital gains tax works and how you can legally minimize your exposure to this type of tax.
What is capital gains tax?
As the name indicates, this is a tax on capital gains. If you buy an asset for $1,000 and sell it later for $1,400, you will make a profit or capital gain of $400. That amount will be taxed by the government. How much tax you will pay on it will, however, depend on (among other things) the type of asset and how long you owned it. As we will see below, your tax liability could be anything between 0% and 37% of the capital gain.
What is very important to realize at this stage is that you will only incur a liability for cCGGT if you sell an asset. Even if you’ve made a profit of 1,000 percent on your original investment, you won’t be taxed on this until you sell that particular asset – at least not in terms of current legislation.
Which types of assets are subject to capital gains tax?
The following are examples of assets that could make you liable for capital gains tax:
- Motor vehicles
- Residential properties
The following are specifically excluded from capital gains tax:
- Depreciable property owned by a business
- Inventory held by a business
- Artistic, literary, or musical compositions
- Photographs, manuscripts, recordings, etc.
- Since January 1, 2018, also patents, designs, and formulas
How much capital gains tax will you pay?
That depends on a few factors, including whether you are single or the head of a household, your taxable income for that year, the type of assets involved, and how long you owned that particular investment.
The following refers to a single individual:
Taxable income calculation example
- Below $40,400 = zero CGT
- From $40,401 to $445,850 = 15% CGT
- More than $445,850 = 20% CGT
If you are the head of a household, the taxable income categories mentioned above change to $80,800, between $80,801 and $501,600, and above $501,600.
Exceptions to the general rule
- If you sell your primary home for a profit, the first $250,000 of that profit will not be subject to capital gains tax, provided you’ve been living in it for at least two years. This amount increases to $500,000 for married couples who file jointly.
- The capital gains tax rate on collectibles such as stamp collections and works of art is equal to 28 percent.
- Selling qualified small business stocks will also incur a 28 percent capital gains tax.
How to calculate capital gains tax
Let’s say you are an individual taxpayer with a taxable income of between $40,401 and $445,850 per year. That means the applicable capital gains tax rate is 15%. Now let’s assume you bought 1,000 stocks at $25 each and sold them two years later for $40 each.
Purchase price = 1,000 x $25 = $25,000
Selling price = 1,000 x $40 = $40,000
Profit = $15,000
You will, therefore, be liable for CGT of 15% x $15,000 = $2,250.
N.B. This only applies if you have owned the stocks for more than a year. If you sold them during the first year, you will be liable for capital gains tax at the same rate as all your other income, which could be as high as 37%. However, this doesn’t even take into account other state taxes.
Ways to pay less capital gains tax
Fortunately, there are quite a few things you can legally do to reduce your capital gains tax liability. These include:
 Adopt a long-term view when it comes to investing
We know it’s difficult to hang on to a stock that seems to be heading for oblivion. That is why, when choosing stocks to invest in, it is important to steer clear of those stocks that have a history of violent volatility. Pick your stocks carefully and invest with the intention of keeping those stocks at least for a year.
Firstly, remember that you don’t have to pay any capital gains tax unless you sell your stocks (or other assets that are subject to capital gains tax).
Secondly, if circumstances force you to sell them within a year, the profit (if any) will be taxed at the same rate as all your other income.
 If you haven’t done so yet, buy a family home
As we already mentioned above, provided that you have owned it for at least two years, the first $250,000 of any profit you make on selling your primary residence is not subject to capital gains tax. For married couples who file jointly, this exemption goes up to $500,000.
This effectively means that for the vast majority of middle-class Americans, the bulk of the profit they make on selling their family home will not be subject to capital gains tax.
 Utilize the benefits of tax-deferred retirement plans
If you invest your savings in a retirement plan, such as an IRA, 403(b), or 401(k), the growth will not attract capital gains taxes. You can even sell individual investments that form part of that retirement plan at a profit without incurring capital gains tax, provided you followed the applicable rules.
If you, on the other hand, invest in a traditional retirement account, when you withdraw from that account one day the capital gains will be taxed in the same way as your other income. Your only hope is that by that time you will be in a lower tax bracket.
In the case of other investments that do not form part of a retirement account, it might be a good idea to postpone selling them until you are no longer working. As mentioned above, by that time you might be in a lower tax bracket so you could end up paying less (or even zero) capital gains tax.
There is one pitfall though: if the capital gain is sufficiently big, it could push you into a higher tax bracket and you could end up paying a significant amount of tax on all your income, including the capital gain.
 Offset capital gains with capital losses
Investors can also offset all or part of their capital gains and possibly even a percentage of their other income if during a particular tax year they also incurred capital losses. Amounts that remain can even be carried over to the following year or years.
Let us, for example, say that you own $10,000 each of three stocks. The one’s price has increased by 10% since you bought it, the second one is still worth the same, and the third one’s price has dropped by 10%. In this case, you can offset the profit of 10% against the 10% loss, which means that your capital gains tax liability will be zero.
If you should ever incur a capital loss that exceeds all your capital gains, you will also be allowed to use it to reduce your ordinary income tax liability for that year, up to a maximum of $3,000.
 Choose the right cost basis
If you have purchased stocks in the same firm or mutual fund at different prices and at different times, you will have to select your cost basis when you sell any of these. Although investors often choose the FIFO (First In, First Out) method as a cost basis, it’s worth knowing that there are also four other methods:
- LIFO (Last In, First Out)
- Specific share identification
- Average cost (mutual fund stocks only)
- Dollar value LIFO
If you decide to sell investments worth a large amount of money, it might be in your best interest to discuss the best way to do this with a tax advisor.
 Selling an asset at the right time can make a big difference to capital gains tax
In the first place, if you never sell an asset you will never have to pay capital gains tax on it. In terms of current legislation, your loved ones will also not be liable for tax on any of the capital gains that asset delivered during your lifetime.
Secondly, if you properly plan the selling of assets such as stocks, you could at least distribute the capital gains tax you have to pay over more than one year. For example, if you sell a third of your stocks just before the end of the tax year, another third during the tax year, and the last third just after the tax year, you can distribute your CGT liability over three years instead of one.
 Carefully consider mutual fund distributions
Those readers who have invested in mutual funds might be liable for capital gains taxes at the end of any tax year. These funds make capital gains and losses throughout the year as they buy and sell different investments.
While during a specific year a mutual fund might incur enough losses on some investments to offset all the profits it made on others, the next year it might have to pass on capital gains to shareholders. This often happens when markets continue to reach new highs.
As the end of the year approaches, investors should check the amount the mutual fund estimates that it would have to distribute to investors in the form of capital gains. If the planned distributions for a specific fund are big enough, it could be worth your while to swap into a different fund in order to sidestep that distribution.
 Donate some of our assets that recorded high capital gains
Unless you have to liquidate some or all of your assets in order to pay your daily living expenses, one option is to donate assets that have appreciated significantly to your heirs or to charity. This could significantly reduce your liability for capital gains tax. Plus, if it’s a charitable donation you will qualify for a tax deduction.
If you donate some of your rapidly appreciating assets to your heirs, they will upon your death get a step up in cost basis, i.e. at the time of your death, the price of the security will form the new cost basis for them. This means they won’t have to pay tax on the capital gains during your lifetime.
 Do not sell your securities but use them as collateral instead
One other option is not to sell an asset that has appreciated in value a lot but rather to use it as collateral for a loan.
Many brokers allow their clients who have a taxable brokerage account to use these investments as collateral for a loan. This will immediately give you access to cash while you will not incur any liability for capital gains tax because you haven’t sold anything. It could be a good option if you just need quick access to emergency funds for a relatively short period.
There are, however, potential pitfalls associated with this solution. If the investment should for some or other reason start dropping in value, the broker will typically ask you to provide additional assets to replenish your account. Furthermore, securities-based loans can’t be used to repay margin loans to purchase other securities.
Although capital gains tax should never be the only factor to take into account when you make or sell an investment, these taxes should definitely be one of the criteria you consider. After all, whether you will incur a 15 percent or 20 percent capital gains tax or not when selling an investment can quite easily make one type of investment product preferable over another one.
Using the services of an experienced financial advisor will make it much easier to navigate the waters of investing. If he or she could work closely with your tax advisor, so much the better.