Capital Gains Tax: Year-End Review

Now's the time to revisit the capital gains tax rules you need to know for year-end planning.

tax form for capital gains and losses
(Image credit: Getty Images)

Capital gains tax applies to many types of investment transactions and, therefore, is an important piece of the overall tax picture for millions of Americans – especially at this time of the year when there's the added complexity of year-end tax planning to worry about. And note that one of the basic concepts behind year-end tax planning is that you generally have greater visibility as to the totality of your income, gains, losses and deductions for the year the closer you get to the end of that year. In addition, the closer you are to a large taxable event, the easier it is to defer that event until the following year. These concepts are particularly important when it comes to the capital gains tax this year, since the recent market turbulence could trigger more year-end changes to your investment portfolio than usual.

But most people don't know much about the capital gains tax – or certainly don't know enough to make informed year-end investment decisions based on the tax consequences of their actions. Eking out a capital gain in the midst of recent market turbulence is hard enough work without having to consider your tax position. Fortunately, though, the following guide will help you understand the basic rules for the federal capital gains tax.

It covers a variety of topics, including what capital gains are, when they're taxed, how to calculate your gain, and what tax rates apply. It also provides an overview of tax loss harvesting, which is a common year-end planning technique. It's not a substitute for sound professional advice, but it will help investors of all sorts understand the general capital gains tax framework and identify areas where professional help is needed.

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Capital Gain Defined

Capital gains are the profit you make from selling or trading a "capital asset." With certain exceptions, a capital asset is generally any property you hold, including:

  • Investment property, such as stocks, bonds, cryptocurrency, real estate, and collectibles; and
  • Property held for personal use, such as a car, house, or home furnishings.

There are, however, various special rules that may affect your property's classification or treatment as a capital asset. For instance, if you sell frequently to customers, your property might not be treated as a capital asset. Instead, it may be considered business inventory – and profits from the sale of inventory aren't taxed as capital gains. So, watch out if you sell too many Gucci handbags or real estate investment properties, as these may be treated as inventory, and the tax on any gains will be at the higher ordinary income tax rates. If you sell or exchange depreciable property to a related person, your gains will be taxed as ordinary income. In addition, intellectual property (e.g., a patent; invention; model or design; secret formula or process; copyright; literary, musical, or artistic composition; letter or memorandum; etc.) is not considered a capital asset if it's held by the person who created it or, in the case of a letter, memorandum or similar property, the person for whom it was prepared or produced.

Plus, although real or depreciable property used in a trade or business is not a capital asset, gains from the sale or involuntary conversion of them may nonetheless be treated as capital gains if they were held for more than one year. So, for all practical purposes, this type of business property is treated as if it was a capital asset.

When Do You Have a Taxable Event?

Capital gains are taxed when they're "realized." Your capital gain (or loss) is generally realized for tax purposes when you sell a capital asset. As a result, capital assets can continue to appreciate (increase in value) without becoming subject to tax as long as you continue to hold on to them. For example, loans against your capital asset don't give rise to a realization event or capital gains tax. For this reason, many real estate investors will refinance properties rather than sell them.

Because you generally control the timing of a sale of your investment property, you can also decide which year your taxable event falls into (e.g., 2022 or 2023). There are a variety of reasons why you might be better off deferring a sale until the next year. For example, now that interest rates are starting to rise, you might prefer to save your money, earn interest on it, and pay the tax on gain from your sale at a later date.

Tax Tip: Make sure to consider the application of estimated taxes, which may require you to remit tax on capital gains quarterly rather than with your year-end tax return. Generally, you must pay 90% of your current year's taxes, or an amount equal to 100% of your taxes from the prior year (110% if your adjusted gross income was more than $150,000), either through withholding or estimated tax payments.

Other types of events besides sales can also give rise to a "realization." For instance, property that is involuntarily converted or taken by the government, or over which you grant an exclusive use right to others, may be treated as sold. A capital gain (or loss) is also realized when property is exchanged for other property.

Although the exchange of property generally is a taxable realization event, special rules apply to "like-kind" exchanges of real estate. Among other requirements, the rules require you to find a replacement property within a certain timeframe, but they may help reduce or eliminate your taxable gain.

Calculating Tax on Your Capital Gain

Your taxable capital gain is generally equal to the value that you receive when you sell or exchange a capital asset minus your "basis" in the asset. Your basis is generally what you paid for the asset. Sometimes this is an easy calculation – if you paid $10 for stock and sold it for $100, your capital gain is $90. But in other situations, determining your basis can more be complicated.

Tax Tip: Since your basis is subtracted from the amount you receive when disposing of a capital asset, you want the highest basis possible so that the taxable portion of your profit is as low as possible.

Your basis can include more than simply your initial purchase price. For example, your basis can also include expenses related to buying, selling, producing, or improving your capital asset that are not currently deductible. This will reduce your gain when you sell. Home improvement expenses, and brokers' fees and commissions that are clearly identified with a particular asset, can raise your basis. Just make sure you keep receipts and other records related to these additional costs. Also note that certain investment-related expenses are miscellaneous itemized expenses and disallowed through 2025 (nor will these expenses increase your basis).

Basis calculations are more complicated if you acquired the capital asset you're selling other than by an ordinary purchase. For example, if you inherit an asset, you generally take a "stepped-up" basis (i.e., the asset's fair market value at the date of the previous owner's death). If someone gives you a capital asset as a gift, the donor's basis carries over to you. If you receive stock from your employer as part of your compensation, your basis is generally equal to the amount included in your taxable pay (i.e., reported on your W-2) allocated to the securities.

What is My Holding Period?

If you hold an asset for more than one year, the gain you realize when you sell it will be long-term capital gain. Long-term capital gains are subject to lower rates of tax than short-term capital gains, which are taxed at ordinary income tax rates. For this reason, you should generally try to hold capital assets for at least one year to get lower rates.

If you sell some but not all your stock in a company, the rules for determining your holding period will depend on your method of accounting for the securities (e.g., FIFO, LIFO, etc., as noted above in relation to determining your basis). You also may get to count the holding period of the person from whom you acquired your stock if you acquired it other than by purchase or other taxable transaction (e.g., if you inherited it).

What Tax Rate Applies to My Capital Gain?

If you have long-term gains, the next thing you need to know is which capital gains tax bracket you fall into – the 0%, 15%, or 20% bracket. Just like with your wages and other ordinary income, the rate at which you're taxed on long-term capital gains depends on whether your taxable income is above or below certain thresholds for the year. Unlike tax rate brackets for ordinary income, once your total income is above the relevant threshold, all your capital gains are taxed at the higher rate (so there may be situations where you may come out ahead by earning less total income for the year).

For 2022, the 0% rate applies to people with taxable incomes up to $83,350 for joint filers, $55,800 for head-of-household filers, and $41,675 for single filers and married couples filing separate returns. The 15% rate applies to people with taxable incomes above these limits and up to $517,200 for joint filers, $488,500 for head-of-household filers, $459,750 for single filers, and $258,600 for married couples filing separate returns. If your taxable income is above the 15% bracket, you will pay tax on your capital gains at 20%.

The IRS recently updated these amounts for inflation. For 2023 the 0% rate applies up to taxable incomes of $89,250 for joint filers, $59,750 for head-of-household filers, and $44,625 for single filers and married couples filing separate returns. The 15% rate applies in 2023 if your income  is between $89,250 and $553,850 for joint filers, $59,750 and $523,050 for head-of-household filers, $44,625 and $276,900 for married couples filing separate returns, and $44,625 to $492,300 for single filers. The 20% rate applies to anyone with income over these amounts.

To take advantage of the varied rates, you might want to defer sales transactions until next year if you expect to be taxed at 20% for 2022 but 0% or 15% in 2023 due to retirement, being in between jobs or having losses on other capital assets. You can also sell capital assets over a span of years to be taxed at 0% or 15% over several years, instead of selling all your assets at once and having them all taxed at the 20% rate.

Special capital gains tax rates apply when certain assets are sold. For example, any gain from the sale of qualified small business stock that isn't excluded is subject to a special capital gains tax rate of 28%. A special 25% rate also applies to something called unrecaptured Section 1250 gain (generally the amount of depreciation previously taken on real property, but limited by the amount of gain you realize from the sale of the property). In addition, gains from the sale of collectibles are taxed at 28%. This includes gains from the sale of art, antiques, stamps, coins, gold or other precious metals, gems, historic objects, or another similar items.

Note, however, that these special rates are maximum rates for people with higher incomes. If your ordinary tax rate is lower than the special rate (i.e., either 10%, 12%, 22% or 24%), your ordinary tax rate may apply to gain on qualified small business stock, Section 1250 gain, or collectibles.

Caution: In addition to the capital gains tax, there is also a surtax that applies to "net investment income." (NII includes, among other things, taxable interest, dividends, gains, passive rents, annuities, and royalties.) If your income is above a certain threshold – $200,000 if single, $250,000 if filing jointly, or $125,000 if married filing a separate return – you generally must pay the additional 3.8% surtax on your capital gains. This surtax doesn't apply to capital gains resulting from the sale of business assets if you're an active participant or real estate professional.

Exclusions From the Capital Gains Tax

The amount of capital gain subject to tax can be reduced if an exclusion applies. Perhaps the best-known capital gains tax exclusion is for the first $250,000 of gain ($500,000 if filing jointly) from the sale of a personal residence you've owned and lived in for two of the last five years. In addition, 100% of your gain from the sale of "qualified small business stock" may also be excluded if you acquired the stock after September 27, 2010. If the stock was purchased before that date, you still may be eligible for a partial exclusion of either 50% or 75% of the gain.

Tax Loss Harvesting

What if 2022 is a year in which you lost money on your investments? A tax loss can be a valuable asset if you use a strategy called "tax loss harvesting," which is based on the ability to offset capital gains with capital losses so that you only pay tax on your net capital gains. However, there's a certain sequence you must follow when offsetting gains with losses. First, short-term losses are used to offset short-term gains, and long-term losses are used to offset long-term gains. Then, if there are any losses remaining, they can be used to offset the opposite type of gain.

For example, let's say this year you have the following gains and losses:

  • $80 long-term gain from selling A Corp. stock;
  • $10 long-term loss from selling B Corp. stock;
  • $20 short-term gain from selling C Corp. stock; and
  • $50 short-term loss from selling D Corp. stock.

You first offset your $50 short-term capital loss against your $20 short-term capital gain, resulting in a $30 net short-term loss. Then use your $10 long-term loss to offset your $80 long-term gain, resulting in a $70 net long-term gain. The $30 net short-term loss can then be applied against your $70 net long-term gain, resulting in an overall net long-term capital gain of $40.

What if you have an overall net capital loss? Up to $3,000 per year in capital losses ($1,500 if married filing separately) can be used to offset ordinary income (such as wages) in computing your tax liability.

If you are not already in a net loss position for 2022 and you have investment assets that have declined in value since you acquired them, you may want to "harvest" a tax loss by selling a sufficient amount of those assets to offset your capital gains plus another $3,000 to use against your ordinary income. You can also carry forward any unused capital losses (i.e., above $3,000) to future tax years until they are used up. But, unfortunately, you can't carry back your capital losses to prior tax years.

Although it may seem counterintuitive to sell an asset that has declined in value (and recognizing a true economic loss) rather than waiting for the value to recover, in the case of stocks it may be possible to replace the investment with something that serves the same basic purpose in your investment portfolio (for example, you sell a single name technology stock, and replace it with a technology index fund). Be careful, however, because the "wash sale" rule prevents you from taking a loss if you repurchase the same or substantially identical securities within 30 days before or after your sale, or if you enter into a contract to acquire such stock or securities. Ordinarily, stock of one company isn't considered substantially identical to stock of another company.

Finally, when you harvest tax losses, make sure to sell securities out of your taxable investment accounts. Generating tax losses in retirement accounts won't help you as gains and losses in those accounts are not generally included in your personal tax return (for Roth IRAs you may be able to include a loss if the account has been fully distributed and the total distributions are less than your basis in the account).

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Principal, Tax, KPMG