What is capital gains tax and how does it work?
January 31, 2023 6 min read
If you own a home or car, you own what’s known as a capital asset. Investments, like stocks and bonds, are other examples. When you sell a capital asset for more than you paid for it, you’ll generally owe capital gains tax.
Learn about how capital gains tax is calculated, when it’s due and how much you might owe when you sell an asset.
- Capital gains tax is generally owed when someone makes a profit from selling a capital asset. Depending on the circumstances, the sale of the asset could be subject to federal and state taxes.
- The IRS categorizes capital gains as short-term when an asset’s been owned for one year or less—and long-term when it’s been owned for more than one year.
- According to the IRS, the maximum tax rate on most capital gains is 15%.
- In some cases, selling an asset may result in a capital loss rather than a capital gain.
What is capital gain?
According to the IRS, “Almost everything you own and use for personal or investment purposes is a capital asset.” For example, a home and its furnishings are generally considered capital assets. Financial investments like stocks and bonds are, too.
A capital gain is the amount of profit that’s made from the sale of a capital asset. Because a capital gain is considered income, it’s generally subject to taxation.
Sometimes, selling an asset can result in a capital loss rather than a capital gain.
Meaning of 'cost basis' and 'adjusted basis' in capital gains tax
When an asset is purchased, the cost to the owner is generally known as its cost basis. For the purpose of filing taxes, the owner also needs to calculate the asset’s adjusted basis.
The adjusted basis is the purchase price of the asset with any increases added to it and decreases subtracted from it. Capital improvements can be an example of an increase; depreciation can be an example of a decrease. Capital gains tax is typically paid on the difference between the asset’s adjusted basis and the amount it’s sold for by the owner.
Here are some specifics on the adjusted basis of certain types of capital assets:
- Property. When things like a home or piece of land are sold, their adjusted basis has to be calculated. The adjusted basis can be impacted by things like improvements to the property and legal fees associated with it.
- Investments. Like with property, an adjusted basis for investments like stocks and bonds that have been sold needs to be calculated at tax time. Factors that could impact the adjusted basis of an investment may include things like a dividend payment or stock split.
Capital gains from inheritance and gifts
When someone sells an asset they’ve inherited or received as a gift, there’s generally no way to calculate an adjusted basis. That’s because they’ve received the item without paying for it.
Instead, a fair market value is typically assigned to the asset. This allows the owner to determine the asset’s adjusted basis if necessary—for example, if they made improvements to an inherited home. It also allows them to determine the amount of their capital gain.
Capital gains from home sales
The rules for paying capital gains tax may also differ when selling a primary residence. As stated by the IRS, single filers may be exempt from paying capital gains tax on the first $250,000. For married couples who file jointly, that figure increases to $500,000.
How much is capital gains tax?
There isn’t any one-size-fits-all cost for capital gains tax. But the IRS says, “The tax rate on most net capital gain is no higher than 15% for most individuals.”
Timing can be a key factor in how much capital gains tax is owed. That’s because the IRS has two general classifications: short-term capital gains and long-term capital gains.
Short-term capital gains tax
A short-term capital gain is money made from selling an asset owned for one year or less. Short-term capital gains are treated as regular taxable income—and are typically taxed in the same way that things like salaries, wages and tips are.
Short-term capital gains are typically taxed at a less advantageous rate than long-term capital gains are.
Long-term capital gains tax
A long-term capital gain is money made from selling an asset owned for more than a year. Long-term capital gains are typically subject to capital gains tax rates of 0%, 15% or 20%, depending on a taxpayer’s total income.
Taxes on long-term capital gains are generally lower than those paid for short-term capital gains.
In some circumstances, capital gains may be taxed at a rate higher than 20%. For example, capital gains on collectibles like coins and art may be taxed up to 28%—and so can certain types of small business stock.
Do you pay capital gains tax immediately?
According to the IRS, capital gains are considered income. And like taxes on other types of income, capital gains tax is a “pay-as-you-go” tax.
That means capital gains are usually taxed during the same year they’re earned.
Can I avoid or reduce capital gains tax owed?
When someone earns a capital gain, they generally can’t avoid claiming it or paying the tax they owe on it. But certain improvements or capital losses on other assets might reduce the tax burden. Talking to a tax expert or reading more from tax agencies like the IRS could help you learn more.