Generally speaking when you buy something and sell it for a profit, you’ve had a capital gain. (When you sell it for less than you paid for it, you have a capital loss.) Both capital gains and capital losses have tax consequences. It can get a little complicated, but if you understand the basics, it’s not rocket science.
Most people think of capital gains (and losses) as terms that apply to stocks and other securities. Mostly they do but in fact any type of property – such as a used car – can become subject to capital gains consideration, depending on circumstances.
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The Basis Part
Capital gains is a form of income and therefore subject to income taxes. The most important term to know is “basis.” This is how much the item cost you before it was sold. That used car you bought for $3,000 and sold for $5,000 had a basis of $3,000. Unless you also paid sales tax, or had it delivered at a cost or someone had to service it to make it drivable. All those things would add to your basis (thereby reducing your capital gains when you sold the car for $5,000).
Short Term Versus Long Term
The amount of taxes you pay doesn’t just depend on the difference between your basis and the selling price. It also depends on how long you waited after obtaining the asset before you sold it. This is called the holding period. If you sell it in a year or less, your gains (profit) are considered short term and you are typically taxed at your regular income tax rate (depending on your tax bracket). If you held the asset a year or longer, you are taxed at a reduced rate of 0%, 15% or 20%, depending on your tax bracket. (Keeping an asset longer almost always results in lower taxes.)
Exceptions And Rules
There are all sorts of exceptions and special rules regarding capital gains. Your home, for example, is typically excluded from capital gains taxes if you meet certain guidelines. Things you buy and resell as part of a business are not taxed at capital gains rates but rather as business income.
There’s a difference between what’s known as realized capital gains and unrealized capital gains.This mostly applies to securities. If you buy stock and it goes up in value 10% over the year you have capital gains but unless you sell the stock, those capital gains are unrealized and therefore not taxed. Once you sell the stock, the difference between your basis and the selling price is now considered realized capital gains and taxable.
Not everything you buy and sell goes up in value or can be sold for more than you paid for it. When you sell something for less than your basis, you have a capital loss and you can use it to offset capital gains or even income from other sources – but only up to $3,000 per year for losses from other sources. Like capital gains, capital losses are also either realized or unrealized. If you buy a stock for $50 and its value drops to $30, but you hang on to it, you can’t claim a loss since you didn’t sell.
If you sell the stock several months later at a $5 loss, that’s all you can claim. There are also rules prohibiting taking a loss on something that wouldn’t be expected to go up in value – like that used car referenced above.
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Looking Ahead To 2018
With the passing of the Tax Cuts and Jobs Act investors naturally wonder how capital gains taxes will be computed for 2018 and beyond. For starters, the basic capital gains tax structure remains unchanged. Long term and short-term gains still have the same definitions and long-term gains are still taxed at 0%, 15% or 20%. The way those taxes are applied has changed slightly. Now they are applied to maximum taxable income levels set by the IRS. (See IRS tax tables for details.) Short-term capital gains are still taxed as regular income.