Large capital gains are good news for your investment account balances, but bad news when … [+]
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Although the stock market had a tough January, if you’ve been investing for a while, you’ve probably racked up capital gains over the past few years. Many projections for the rest of 2022 point to positive stock market returns. Earning money on your stock market investments is great, but you should be aware of the capital gains taxes you may owe when buying and selling your holdings.
The amount you will have to pay in capital gains tax on the gains from your investments will mainly depend on three factors.
1) By how much the value of your investments has increased
2) How long you have held your investments
3) Your overall income from all sources
When you sell an investment (stocks, bonds, mutual funds, ETFs, real estate, cryptocurrency) for more than your cost base (essentially what you paid for the investment), your net profit will be taxed either long-term or short-term capital gain at the federal level. At the state level, your capital gains taxes owed will depend on your particular state. For example, California taxes capital gains as regular income, with a top tax bracket of 13.3% at the state level. OUCH!
The length of time you hold an investment will determine whether your gains will be taxed at long-term or short-term capital gains rates. If you have held your investment for more than a year, you will be taxed at the long-term capital gains rate. For investments held for less than a year, your capital gains will be taxed at the short-term capital gains rate.
Let’s see how your long-term capital gains are actually taxed at the federal level. Generally, long-term capital gains will receive favorable tax treatment over taxes payable on short-term capital gains. Long-term capital gains are taxed at the rate of 0%, 15% or 20%, depending on a combination of your taxable income and marital status.
For single filers, you can qualify for the zero percent capital gain rate if you have income below $41,675 in 2022. Most single people with investments will fall under the 15% capital gain rate, which applies to income between $41,675 and $459,750. Single filers with incomes above $459,750 will be affected by the 20% rate on long-term capital gains.
The brackets are a bit larger for married couples filing their taxes jointly, but most will see their investment income affected by marriage penalty tax. Married couples with incomes of $83,350 or less remain in the 0% tax bracket, which is great news. You must like non-taxable income. However, married couples earning between $83,350 and $517,200 will have a capital gains rate of 15%. Those with incomes above $517,200 will find themselves hit by a long-term capital gains rate of 20%.
Medicare Capital Gains Surtax
There may be additional taxes on investment income or lost tax deductions for people with higher incomes. For example, married taxpayers with incomes over $250,000 will also have to pay an additional surtax of 3.8% on net investments. (The Medicare surtax applies to income over $200,000 for single filers.) This Medicare surtax applies to all investment income, whether the capital gains are long-term or short-term capital gains. . This threshold is not linked to inflation, so each year more taxpayers can expect to be affected by the Net Investment Income Tax (NIIT).
2022 short-term capital gains rate
When you realize short-term capital gains, they are generally taxed at the ordinary income rate. If you hold an investment for less than a year and then sell it, any gain or loss will be treated as a short-term capital gain or loss. The good news is that up to $3,000 of short-term losses can be deducted from regular income each year. This offers a great opportunity to reduce your taxes through tax-loss harvesting.
Pay less tax with tax-loss harvesting
The boom in the stock market in recent years does not mean that all investments have experienced large increases in value. This is especially true with the recent volatility we’ve seen so far in 2022. I often take on new clients whose former financial advisors seemed to have had the golden touch for choosing terrible investments (probably part of why they’re l former financial adviser), as well as terrible market timing.
On the positive side, it has provided them with opportunities to use tax-loss harvesting to reduce taxes owed on their regular income. We were able to capture over $3,000 in short-term capital losses, which they used to offset regular income. Likewise, we were able to use some of the other investment losses to offset the investment gains incurred on their compensation at work.
Taxes on investment gains in retirement accounts
Earnings in your 401(k), traditional IRA, Defined benefit pension plan, 403(b) and tax-sheltered annuities (TSA) will be tax-deferred. You won’t owe any tax on the earnings in your retirement accounts until you make a withdrawal. If you have a Roth 401(k) or Roth IRA, your withdrawal will be tax-free, assuming you follow Internal Revenue Service (IRS) rules.
Taxation of real estate capital gains
There are tax benefits when you sell real estate, especially your primary residence. When you sell your principal residence, you can avoid paying a substantial amount of tax on your gains. In many parts of the country, you may not owe any capital gains tax when selling your principal residence.
Single (unmarried) homeowners can exclude up to $250,000 of capital gains on the sale of their principal residence. This number doubles to $500,000 for a married couple selling their primary residence. There are a few rules you need to follow to get this significant tax relief; specifically, you must have lived in your primary residence for at least two of the past five years.
You don’t have to live in the Playbay mansion to owe capital gains taxes when you sell real estate, … [+]
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Keep in mind that the taxable gain is based on your home’s cost base, which may not be the same as your original purchase price. So, be sure to keep track of all those home improvements or remodeling projects you’ve spent money on over the years. Even things like a new water heater or a new roof can increase the cost base of your home. The higher your base price, the lower your tax bill will be once you sell your home. For example, if you buy a McMansion in West Hollywood for $5 million and then spend $1 million remodeling it, you will have a cost base of $6 million. If you’re married and have lived there for two of the past five years, you could sell it for $6.5 million without having to pay capital gains tax on the sale.
The rules are slightly different for investment property. You will owe capital gains taxes on the net proceeds from the sale, but you will also owe gains on any accumulated depreciation you received while you owned the property. This process is known as depreciation recovery. This is too complicated a subject to discuss here, completely. I just need you to know that on investment properties, your cost base is probably less than what you invest in the property. Speak with your Certified Financial Planner and CPA before selling your investment property to ensure you understand the tax implications. If you are selling one property to buy another, you may be able to defer taxation with a 1031 exchange.
Should you try to avoid short-term capital gains?
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Should short-term capital gains be avoided?
Taxes should only be part of the equation when deciding whether to buy or sell investments. However, you need to know how long you have held the investment and what taxes are due when you sell. In many cases, especially if you are about to have held the investment for a year, you will want to try to avoid being hit by short-term capital gains. The IRS tax code encourages long-term investing, or holding an investment for at least one year. In most cases, long-term capital gains rates will be lower than your earned income tax rates.
Reducing the tax burden on your investment can help increase your net after-tax returns. Work with your financial planner and CPA to ensure you’re investing in the most tax-efficient way and avoiding unnecessary taxes.
