Although the stock market had a rough January, if you have been investing for any amount of time, you have likely accumulated some capital gains over the past few years. Many projections for the rest of 2022 point to some positive stock market returns. Earning money on your investments in the stock market is great, but you need to be aware of the capital gains taxes that you may owe when buying and selling your holdings.
How much you end up owing in capital gains taxes on your investments’ gains will mostly depend on three factors.
1) 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 basis (essentially, what you paid for the investment), your net profit will be taxed as either a long-term or short-term capital gain at the federal level. At the state level, your capital gains taxes due will depend on your particular state. For example, California taxes capital gains like regular income, with a top tax bracket of 13.3% at the state level. OUCH!
How long you have held an investment will determine whether your gains will be taxed at long-term or short-term capital gains rates. If you have owned your investment for more than one year, you will be taxed at long-term capital gains rates. For investments held less than a year, your capital gains will be taxed at the short-term capital gains rates.
Let’s take a look at how your long-term capital gains are actually taxed at the federal level. Generally, long-term capital gains will have favorable tax treatments when compared to the taxes owed 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 tax filers, you can benefit from the zero percent capital gains rate if you have an income below $41,675 in 2022. Most single people with investments will fall into the 15% capital gains rate, which applies to incomes between $41,675 and $459,750. Single filers with incomes more than $459,750 will get hit with the 20% long-term capital gains rate.
The brackets are a tiny bit bigger for married couples who file their taxes jointly, but most will see their investment income hit by the marriage tax penalty. Married couples with incomes of $83,350 or less remain in the 0% tax bracket, which is excellent news. You gotta love tax-free income. However, married couples who earn between $83,350 and $517,200 will have a capital gains rate of 15%. Those with incomes above $517,200 will find themselves getting hit with a 20% long-term capital gains rate.
Medicare Surtax on Capital Gains Income
There may be additional taxes on investment income or lost tax deductions for people with higher incomes. For example, married taxpayers with incomes of more than $250,000 will also be required to pay an additional 3.8% net-investment surtax. (Medicare surtax applies to incomes above $200,000 for single filers.) This Medicare surtax is applied to all investment income regardless of whether the capital gains are long-term or short-term capital gains. This threshold is not pegged to inflation, so each year, more taxpayers can expect to get hit with the Net Investment Income Tax (NIIT).
Short-Term Capital Gains Rates 2022
When you realize short-term capital gains, they are typically taxed as ordinary income rates. If you hold an investment for less than one year and then sell it, any gains, or losses, will be treated as short-term capital gains or short-term losses. The good news is that up to $3,000 of short-term losses can be deducted against regular income each year. That provides a great opportunity to lower your taxes with tax-loss harvesting.
Pay Fewer Taxes with Tax-Loss Harvesting
The soaring stock market of the past few years doesn’t mean all investments have seen large increases in value. This is especially true with the recent volatility we have seen so far in 2022. I often take on new clients whose previous financial advisors appeared to have had the golden touch for picking terrible investments (probably part of why they are the previous financial advisor), as well as terrible market timing.
On the bright side, this provided some opportunities for them to use tax-loss harvesting to reduce the taxes due on their regular income. We were able to capture more than $3,000 in short-term capital losses, which they used to offset regular income. Similarly, we were able to use some of the other investment losses to offset investment gains incurred on their equity compensation at work.
Taxes on Investment Gains in Retirement Accounts
Gains 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 taxes on the gains 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 Capital Gains on Real Estate
There are some tax advantages when you are selling real estate, specifically your primary residence. When you sell your primary residence, you may be able to avoid paying a substantial amount of taxes on your gains. In many parts of the country, you may not owe any capital gains taxes when selling your primary residence.
Homeowners who are single (not married) may be able to exclude up to $250,000 in capital gains on the sale of their primary 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 large tax break; most notably, 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, … [+]
AFP via Getty Images
Keep in mind that the taxable gain is based on the cost basis of your home, which may not be the same as your original purchase price. So, make sure to keep track of all those home improvements or remodeling projects that you have spent money on over the years. Even things like a new water heater or roof can increase the cost basis of your home. The higher your cost basis, the smaller your tax bill will be once you eventually sell your home. For example, if you purchase a McMansion in West Hollywood for $5 million, then spend $1 million remodeling it, you will have a cost basis of $6 million. If you are married and have lived there for two of the past five years, you could sell it for $6.5 million without having to pay any capital gains taxes on the sale.
The rules are slightly different for investment properties. You will owe capital gains taxes on the net profit from the sale, but you will also owe gains on the cumulative depreciation benefits you have received while you owned the property. That process is known as depreciation recapture. It is a topic too complicated to discuss here, completely. I just need you to be aware that on investment properties, your cost basis is likely less than you put into the property. Talk with your certified financial planner and CPA before selling your investment property to make sure you understand the tax consequences. If you are selling one property to buy another, you may be able to defer taxation with a 1031 exchange.
Should your try and avoid Short Term Capital Gains?
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Should You Avoid Short-Term Capital Gains?
Taxes should only be part of the equation when making decisions on whether to buy or sell investments. All the same, you should be aware of how long you have held the investment and what taxes are due when you sell. In many cases, especially if you are close to having held the investment for a year, you will want to try to avoid getting hit with short-term capital gains. The IRS tax code encourages long-term investing or holding an investment for at least a year. In most cases, long-term capital gains rates will be lower than your earned income tax rates.
Reducing the tax drag on your investment can help increase your net after-tax investment returns. Work with your financial planner and CPA to ensure you are investing in the most tax-efficient manner and avoiding paying unnecessary taxes.