The Complete Definition of Capital Gains Tax
You’ve heard the term capital gains tax. But what is that exactly? Is that something you pay? If so, when?
Whenever you sell something — a house, car, company stock, or even gold or silver coins — you typically either make or lose money on the investment. That’s also referred to as a gain or loss.
In many circumstances, the item you sold is labeled as a capital asset. If you sell a capital asset and earn a profit from that sale, you are then subject to capital gains tax.
To determine whether you have to pay capital gains tax, you first have to know whether your item is a capital asset.
Capital asset definition
Most personal items you own, such as a car, shares of stock, mutual funds, or real estate, are capital assets. According to the Internal Revenue Service (IRS), almost everything you own and use for personal purposes, pleasure, or investment is a capital asset.
Businesses can own capital assets, too. Things like equipment, machinery, buildings, and patents are capital assets for a business.
If you’re musically creative, however, songs you’ve written or the copyrights to your music are not considered capital assets.
Calculating capital gains
Fortunately, you seldom have to pay capital gains tax on the entire amount of proceeds from a sale. Typically, you’re only responsible for paying tax on the gain. And if you have a loss, you may be able to deduct it.
A capital gain is the dollar amount you made on the sale that’s above the original amount you paid for the asset. Think of it as your profit. To calculate it, take the amount you received minus the amount you originally paid.
For example, if you bought one ounce of gold years ago for $300, and you sell it for $1,200, the calculation looks like this:
$1,200 (proceeds of sale) – $300 (original purchase price) = $900 (capital gain)
Conversely, if you bought that one ounce of gold for $1,200, and you sell it for $300, you have a loss of $900.
The amount you originally paid for an asset is your cost basis. Generally, it is also your tax basis.
However, in some cases, it’s more complicated than that.
If you take depreciation deductions for the asset on your tax return, your tax basis reduces by the deductions. A lower tax basis means a higher taxable gain when you sell. On the flip side, if you make improvements to the asset, the amount you spend increases your tax basis.
For example, if you add a deck to a rental house, the cost of the deck increases your tax basis.
Your tax basis adjusted for depreciation deductions, improvements, and any other adjustments is called your adjusted basis.
That is the amount you use to determine if you have a capital gain or loss when you sell an asset.
Where to report capital gains and losses on your income tax return
Report all capital gains and losses on Schedule D, Capital Gains and Losses. Tax software programs, like the TaxAct products, make completing the right forms easy because it adds your information to the appropriate spot within your return for you.
Benefits of capital gains
Typically, capital gains are taxed at a more favorable rate than your standard salary or wages, which is why that form of income has a greater impact on your pocketbook. However, that isn’t true in every case as not all capital gains are the same. The tax rate varies dramatically based on the classification of the capital gain.
Capital gains are broken down into two categories: short-term and long-term.
Short-term capital gains vs. long-term capital gains
A short-term capital gain refers to any profit made from the sale of an asset you owned for one year or less. That type of gain does not benefit from any special tax rate as it’s taxed the same as your ordinary income.
A long-term capital gain is different. It refers to any profit made from the sale of an asset you owned for more than one year. In that case, you can benefit from a reduced tax rate on your gain. That rule was created to encourage long-term investment in the economy. You can learn more about long-term capital gains here. Insert link to new capital gains tax article.
How to estimate the tax on a capital asset
Another way to quickly determine how much capital gains tax you owe on a sale is to estimate the gain based on your tax rate.
If you sell a capital asset you owned for one year or less, you will generally pay tax at your ordinary income tax rate.
Let’s say you sold stock you owned for six months at a profit of $10,000. If your marginal federal income tax rate on your ordinary income is 25 percent, your tax bill is 25 percent of the $10,000 profit. That means you’ll owe about $2,500 in tax on your short-term capital gain.
If you owned the asset for more than one year and made $10,000 in profits after you sold it, the tax rate is lower. In turn, that long-term gain should have a greater impact on your bank account since you’ll keep more of the money.
You can use this Capital Gains Tax Calculator to help estimate your tax liability.
Be aware that capital gains can push you from one tax bracket to another (see How Tax Brackets Work).
Another caveat: substantial capital gains can increase your adjusted gross income. That can change the number of tax benefits you receive for various deductions and credits.
Due date for capital gains tax
When you file your income tax return, that’s when you should tell the IRS about your capital sales. That’s also generally when the tax is due. However, that doesn’t mean you don’t need to do anything until then. It may be advantageous to start paying that bill much sooner in the form of quarterly estimated tax payments.
Quarterly estimated tax payments and capital gains
The IRS may require you to make quarterly estimated tax payments if you earn substantial income that’s not subject to tax withholding, such as from the sale of an asset.
For tax year 2018, you may need to make quarterly payments if:
- you owe more than $1,000 when you prepare your tax return, and
- your withholding and refundable credits are less than 90 percent of your total tax or 100 percent of your tax for the previous year
If you don’t pay estimated taxes, you could face penalties and interest charges on the amount of tax you should have paid quarterly.
Estimated tax payment due dates
Generally, you should pay the capital gains tax in the quarter the sale occurred.
The 2022 quarterly due dates for estimated tax payments are as follows:
- First-quarter payments: April 18, 2022
- Second-quarter payments: June 15, 2022
- Third-quarter payments: Sept. 15, 2022
- Fourth-quarter payments: Jan. 17, 2023
When a due date falls on a weekend or holiday, your quarterly payment is due the following business day.
Even if you are not required to make estimated tax payments, you may want to pay the capital gains tax shortly after the sale while you still have the profit in hand.
Making quarterly estimated tax payments
The TaxAct products can help determine your quarterly payments and print out a quarterly payment voucher for you. You’ll need to print the voucher, attach a check or money order, and mail it to the IRS before the due date.
Another option is to use Electronic Funds Withdraw (EFW) to have a payment deducted from your bank account automatically. You can set that up using TaxAct’s software.
The IRS also allows you to make payments online or through an automated phone system with a credit or debit card. Unfortunately, there is an additional convenience fee for that service.
If you need to pay estimated taxes and other payments regularly, it’s worth the time to set up an account with the Electronic Federal Tax Payment System (EFTPS). That is a service provided for free by the U.S. Department of Treasury.
Alternatives to estimated tax payments
Instead of making estimated tax payments, you can choose to increase your income tax withholding on your ordinary income to cover the additional tax.
To increase your withholdings, you must file a new Form W-4 with your employer’s payroll department. That can be a relatively painless way to cover the additional tax. Just don’t forget to adjust your income tax withholding again after January 1 when the capital gain amount is no longer included in your income for the next year (see How to Fill out Form W-4 to Keep More Money in Your Pocket).
Another strategy is to plan other tax events to counteract the capital gains tax.
For example, you could sell an asset that has gone down in value, make a business investment, or contribute to charity during the same year as the sale. Losses on investments are used to offset the tax on any capital gains, which means you’ll pay less tax. You can also claim the money donated to charity as a tax deduction to reduce your taxable income and, ultimately, reduce the amount you must pay in tax.
It’s important to note, however, that losses can only be deducted against capital gains of the same nature. For example, short-term capital losses are only deductible against short-term capital gains.
Additionally, you can only deduct up to $3,000 of net long-term capital losses in a given tax year. Any excess net long-term capital losses are carried forward until there is sufficient capital gain income, or the $3,000 net long-term capital loss limitation is exhausted.