Capital gains taxes become important when you sell an asset for more than its cost basis.
Stocks, mutual funds, exchange-traded funds (ETFs), real estate, businesses, and collectibles can produce capital gains. Understanding how gains are taxed can help you make decisions and avoid surprises.
You generally do not owe tax simply because an investment increases in value. In most cases, a gain is not recognized until you sell the asset. Until then, it is considered unrealized.
What Is a Capital Gain?
A capital gain is the difference between an asset’s cost basis and selling price. Cost basis generally refers to what you paid for the asset, although it may be adjusted over time. If you buy a stock for $10 per share and later sell it for $15, your capital gain is $5 per share.
Short-Term vs. Long-Term Capital Gains
How long you own an asset can affect its tax treatment. If you hold an asset for one year or less, the gain is considered short term and taxed as ordinary income. It is added to your taxable income and taxed at your applicable federal rate. If you hold the asset for more than one year, the gain qualifies as long term. Long-term capital gains may be taxed at 0%, 15%, or 20%, depending on your taxable income.
Some higher-income taxpayers may also owe the 3.8% Net Investment Income Tax. For married couples filing jointly, this additional tax generally applies when modified adjusted gross income exceeds $250,000.
Factors That Affect Capital Gains Taxes
Before selling an appreciated asset, consider your cost basis, holding period, taxable income, state tax rules, and whether the investment is held in a taxable or retirement account.
Retirement Accounts Are Different
Investments bought and sold inside Traditional IRAs, Roth IRAs, and other retirement accounts do not create capital gains taxes with each trade. Instead, taxes are determined by the rules governing distributions. Capital gains planning is most relevant for taxable brokerage accounts, where selling an appreciated investment may create an immediate taxable event.
Planning Opportunities
Several strategies may help manage capital gains taxes.
- Inherited assets often receive a step up in basis, meaning the beneficiary’s basis is generally adjusted to the asset’s fair market value at the original owner’s death. This may reduce the taxable gain when the asset is sold.
- Donating appreciated securities directly to charity may help avoid capital gains taxes while potentially creating a charitable deduction.
- Taxpayers with lower taxable income may qualify for the 0% federal long-term capital gains rate. This can create planning opportunities during lower-income years, including early retirement.
- Owners of qualifying investment real estate may consider a 1031 exchange, which allows gains to be deferred when IRS requirements are met.
- Planning can also help investors diversify concentrated positions, generate retirement income, and coordinate gains with other tax strategies.
A capital gain is generally positive because it means an asset increased in value. The key is understanding the tax impact when that gain is realized. Cost basis, holding period, taxable income, account type, and state of residence can all affect the outcome. Capital gains taxes should be considered as part of your broader financial, investment, and tax strategy. The goal is to make wise decisions that maximize what you keep after taxes while supporting the life you have worked hard to build.
Financial Enhancement Group is an SEC Registered Investment Advisor.
This content is for educational purposes only and is not intended to be financial, investment, or tax advice. Please consult with a qualified advisor regarding your specific situation.
