How is capital gains tax calculated?

Understanding capital gains tax is essential for savvy investors. If you're aiming to maximize your returns, you need to know when you'll encounter capital gains taxes and how to deal with them. In this article, Wealth Enhancement Group walks you through the basics of what capital gains tax is, how it's calculated, and the best strategies you can use to minimize your tax burden, whether you're a retiree or a young professional.

What Is the Capital Gains Tax?

Capital gains tax is a levy on profit made from selling an asset, whether it be a stock, a real estate holding, or a business interest. Essentially, it's a tax on the growth of your investments. This tax is only triggered upon the sale of the asset, not while you hold it.

How Does the Capital Gains Tax Work?

When you sell an asset for more than you paid for it, you have what's defined as a "capital gain." The amount of gain subject to the capital gains tax is the difference between the sale price and what you originally paid for the asset (which is known as the "cost basis"). You'll pay the capital gains tax on this difference.

For example, let's say you bought stock five years ago for $100. Today, that stock has appreciated to $250, and you decide to sell it. Your cost basis for the sale is $100, and your capital gain is $150. The capital gains tax would be levied against the $150 portion of your profit (check out the next section to determine which capital gains tax rate you'd use).

As a note, the capital gains tax is separate from your regular income tax. Your regular income tax is calculated based on your earned income like wages, salaries, and other forms of ordinary income. Capital gains (like the sale of a stock or business asset) don't typically add to your earned income for the purposes of calculating your regular income tax.

Capital Gains Tax Rates 2023: Short vs. Long

Capital gains taxes are divided into two different buckets: short-term capital gains and long-term capital gains. Each bucket has its own corresponding tax rate. Figuring out which capital gains tax rate to apply is straightforward:

• Short-term capital gains rate: For assets you've held for less than one year, you'll apply your ordinary income tax rate to the capital gain.
• Long-term capital gains rate: For assets you've held for more than a year, you benefit from a lower tax rate. Depending on your overall income, your capital gains tax rate will either be 0%, 15%, or 20%.

Single

• 0% rate: Up to $44,625
• 15% rate: $44,626 - $492,300
• 20% rate: $492,301 or more

Married filing separately

• 0% rate: Up to $44,625
• 15% rate: $44,626 - $276,900
• 20% rate: $276,901 or more

Married filing jointly:

• 0% rate: Up to $89,250
• 15% rate: $89,251 - $553,850
• 20% rate: $553,851 or more

Head of household:

• 0% rate: Up to $59,750
• 15% rate: $59,751 - $523,050
• 20% rate: $523,051 or more

To finish the quick example from above, let's say you're married filing jointly, and your taxable income is $300,000. In that case, you'd pay the 15% rate on your $150 gain from the sale of the stock, or $22.50 in capital gains tax.

How Is Capital Gains Tax Calculated?

Get out your pencils. Calculating capital gains tax involves three steps:

1. Determine the cost basis of your assets, which is the original value of the asset, plus any improvements and minus any depreciation.
2. Subtract the cost basis from the selling price. The resulting number is your capital gain (or loss).
3. Apply the appropriate tax rate—either the short-term rate, or the long-term rate—depending on how long you've held the asset.

The resulting number is the capital gains tax levied on the sale of your asset.

Now that you know how to calculate capital gains tax, here is an in-depth example.

Calculating Capital Gains Tax: In-Depth Example

Dale purchased a commercial office building in 2009 for $1,800,000. After operating the building for more than a decade, he decided to sell it in 2023 for the price of $3,450,000. During 2023, Dale's tax filing status was married filing separately, and his ordinary income was $415,000.

Given this paragraph of information, we can calculate the capital gains tax Dale will pay on the office building. Let's follow our three steps:

Step 1: Determine the Cost Basis

Dale's cost basis in the property is the original purchase price of $1,800,000.

Step 2: Calculate the Capital Gain

To find the capital gain, subtract the cost basis from the selling price. $3,450,000 -­ $1,800,000 = $1,650,000. Thus, Dale's capital gain from the transaction is $1,650,000.

Step 3: Calculate the Tax Owed

Because Dale held the property for longer than one year, the long-term capital gains tax rate will apply. Given Dale's ordinary income of $415,000 and his filing status as married filing separately, he will fall into the 20% long-term capital gains tax bracket for 2023. We can then complete our calculation: $1,650,000 x 0.20 = $330,000. In this scenario, Dale owes $330,000 in long-term capital gains tax on the $1,650,000 profit from the sale of the commercial property. 

This amount is separate from any ordinary income tax Dale would owe on his $415,000 income for the year.

But wait, there's more!

Tax-savvy readers may be eager to point out some of the additional considerations glossed over in this example. In the sale of his office building, Dale needs to account for more than just a simple calculation:

1. State and local taxes: In addition to the federal capital gains tax, Dale could be subject to state and local capital gains taxes, which can vary wildly. For example, Dale's state could impose a 5% levy on capital gains, which would see him cough up an additional $82,500.
2. Net Investment Income Tax (NIIT): The net investment income tax is an additional tax applied to the investment income of specific individuals, estates, and trusts. If your net investment income (NII) or modified adjusted gross income (MAGI) is over a certain threshold, you may owe this 3.8% surtax. In Dale's case, his MAGI (ordinary income + capital gains) is far over the $125,000 threshold for married filing separately. Thus, he will pay an additional 3.8% to the federal government on his capital gain, or $62,700.
3. Depreciation & depreciation recapture: The IRS allows commercial real estate investors to depreciate the value of their properties over time. Say Dale took $300,000 in depreciation deductions over the years as his office building aged to reduce his annual tax bills. His original cost basis would be reduced by the depreciation he claimed, adjusting it to $1,500,000 (and forcing a recalculation of all the other numbers above). Upon the sale of the depreciated asset, the IRS compels investors to "recapture" that depreciation by paying a 25% tax on the value they depreciated, which would add an additional $75,000 to Dale's tax bill.

And that's not the end of the story for Dale! A transaction like this could also be affected by capital improvements, tax credits, and more, which would further complicate his tax considerations. 

Capital Gains Tax Strategies: How to Avoid, Reduce, or Minimize Capital Gains Taxes

Strategic planning can help you reduce your capital gains tax obligations. Read on for three strategies you can use to reduce capital gains.

Tax-Loss Harvesting

Tax-loss harvesting is a strategy that involves selling underperforming investments to offset gains in other assets. By realizing losses simultaneously with gains, investors can effectively neutralize their gains and potentially reduce the amount they owe in capital gains taxes.

Note: If you sell off a particular asset to harvest the loss, you can't replace it with a "substantially identical" asset within 30 days of the sale. This is known as the "Wash Sale Rule."

Timing Your Sales

Strategic timing of your asset sales can also significantly impact your tax bill. If you've held an asset for under one year, waiting until a full year has elapsed will allow you to access the favorable long-term capital gains tax rates instead of the higher short-term rates. Additionally, if you can time the sale during a year in which your income is lower, you could avoid capital gains taxes entirely.

Gifting or Donating Assets

Another strategy to reduce your capital gains tax is to gift or donate the appreciated assets to family members in lower tax brackets or to charitable organizations. Doing so requires you to understand the annual gift tax exclusion and the lifetime gift tax exclusion. For 2023, the annual gift tax exclusion allows you to gift $17,000 in assets to each other individual before it starts counting against your lifetime exclusion. The current lifetime exclusion is $12.92 million.

When gifting to a family member, the recipient assumes the asset's original cost basis, potentially resulting in less tax liability if they're in a lower tax bracket than you. When donating to charity, you can typically deduct the market value of the asset at the time of the donation from your taxable income, which reduces your overall tax liability.

Capital Gains Tax Rules and Considerations

Capital gains taxes apply differently to a few different types of assets. Here are three of the main tax rules and considerations for you to look out for.

Collectibles

Capital gains from the sale of collectibles, such as art, classic cars, or gold coins, are taxed differently than other types of assets. As of 2023, the maximum federal tax rate for long-term gains on collectibles is 28%.

Wash Sale Rule

The wash sale rule prevents investors from claiming a capital loss for tax purposes if they buy a "substantially identical" investment within 30 days of the sale. This is to stop investors from tax-loss harvesting (described above) with no risk. For instance, if you own a share of a particular total market index fund, you can't sell it for a loss and harvest the tax benefits if you immediately repurchase a different total market index fund. To harvest the loss in this case, you'd have to wait 30 days before purchasing.

Selling a Residence

Special rules also apply when you're selling your primary residence. A single individual can exclude up to $250,000 of their capital gain from taxation, and a couple filing jointly can exclude up to $500,000. Any portion of the gain above these exclusion limits is subject to capital gains tax. In either case, the individuals must have lived in the residence for at least two of the last five years before the sale. It's also worth noting that you can't use this exclusion more than once every two years.

Understanding How to Calculate Capital Gains Tax Isn't Always Easy

Knowing how to calculate your capital gains tax burden is crucial for making informed decisions about your investments—and your financial future as a whole. Whether you're selling stocks, your primary residence, or even your collection of vintage Volkswagens, knowing the rules can save you significant money. However, tax laws are notoriously complex and subject to change at any juncture.

This information is not intended to be individualized tax advice. Discuss your specific situation with a qualified tax professional.