As Tax season is coming to an end you may be reevaluating your portfolio or hearing about capital gains from your CPA or financial advisor. Capital gains tax is important to understand because it can have a major impact on your investments and ultimately your wallet.
Capital gains tax is defined as the amount of tax you will pay when selling an asset. The difference between your sales price and cost is the amount subject to capital gains tax. This amount may receive preferential tax treatment thereby lowering how much you will pay in taxes.
Assets that are sold and have appreciated over the years may be subject to preferential tax treatment. This can create thousands of dollars in tax savings. It is prudent to understand the rules and plan appropriately when buying and selling assets either in your business or investment portfolio.
I would like to break down the concept of capital gains tax and why it is important to understand. Also, I will explain how it can present some great planning opportunities for your investment portfolio.
- Knowing your cost basis
- Capital gains tax impact on investments
- Long term capital gains
- Short term capital gains
- 2022 income tax brackets
- Standard deductions
- Tax loss harvesting and tax gain harvesting
- Reporting capital gains on your taxes
Determining Your Cost Basis in the Context of Capital Gains
Capital gains, or losses for that matter, can occur when you sell an asset. This can be in relation to anything you own from a house, car, or investments like stocks and bonds. Stocks and bonds are probably the most common assets people associate with capital gains.
When you purchase an asset you establish your cost basis. This is an accounting term used to show the cost of financial assets or what you have paid for it. For simplicity, let’s just say that your purchase price is your cost basis. So if you purchase a stock for $50/share and buy 100 shares your cost basis is $5,000. If you buy a house for $250,000 that will be your cost basis as another example.
The rules can get more complicated for a house, and much more so when you are dealing with a business, since the basis can be increased or decreased each year depending on improvements or deductions taken.
Adjusted cost basis is a topic for a separate discussion but knowing your basis is step one in determining your capital gains or capital losses. Take comfort in knowing that If you are investing in a taxable investment account the cost basis will be tracked by the custodian when securities bought and sold inside the account.
Long Term Capital Gains Tax vs. Short Term Capital Gains Tax
Capital gains are established once your asset is sold. You take the sales price and subtract your cost basis. This will be your gain or loss on the sale of the asset. The amount above or below your basis is considered a capital gain or loss. This is where the actual capital gains tax comes into play.
You will either have a short term capital gain/loss or a long term capital gain/loss. Your holding period determines how you categorize the gain or loss for taxation purposes. If you have held the asset for less than one year it will be considered a short term capital gain/loss.
If you have held the asset for more than a year it will be considered a long term capital gain/loss. The difference here is that short term capital gains are included in ordinary income and long term capital gains are taxed at lower rates. If you sell multiple assets, your short term capital gains and long term capital gains will be netted together to establish the type.
2022 Income Tax Brackets and Impact on Capital Gains
There are a number of variables that determine your income tax rate but let’s focus on your income and filing status for the year. An easy way to think about your marginal tax rate is taking your w2 wages or business net income and subtracting your standard deduction or itemized deductions to arrive at your taxable income. I have included a chart below for 2022’s marginal income tax rates, capital gains rates, and the standard deductions from Tax Foundation – 2022 tax rates, which is a great tax resource.
Example – Let’s say you’re single and you have $200,000 of taxable income for the year 2022. If you look at the chart you can see your last dollar earned will be taxed at 32%. The income tax rates are on a tiered scale opposed to a flat rate. Your effective tax rate which is pretty much the average tax rate will be slightly less than this, since every dollar is not taxed at 32%.
If you sell a stock for $50,000 and you have $20,000 for your cost basis you will have a capital gain of $30,000, which would be subject to capital gains tax.
If you held this stock for less than a year you would be taxed at your ordinary income rate of roughly 32%. If you held this stock for more than a year it would be subject to long term capital gains rates and be taxed at 15%.
For comparison purposes, that is roughly $9,600 vs. $4,500 in tax liability. That is a total difference of $5,100. As you can see, this is a significant difference and can be material amounts of money.
Ways to Minimize Capital Gains Taxes
Tax loss harvesting and tax gain harvesting occur when you sell an investment and buy a different one in its place. You are harvesting the losses or gains by intentionally selling the position and buying a different one thereby keeping the money invested. The goal is to take the tax hit now allowing you to take advantage of the lower capital gains rates. Capital losses can be used to offset future capital gains or be deducted against ordinary income up to $3,000.
Capital losses can carry forward into future years. One thing to be mindful of when harvesting losses is that you cannot buy a substantially identical security or fund. This is defined by the IRS and if it is violated you will be subject to the wash sale rules, where the loss will be disallowed.
Reporting Capital Gains
Capital gains are reported on schedule-D of your tax return. Your custodian will provide you with a 1099 that shows your capital gains for the year. This information is to be used to complete your schedule-D which will flow to the front of your 1040 personal income tax return.
It is very important to keep up with all records and proceeds from the sale of any assets that are subject to capital gains tax. These are common records and questions a CPA or tax preparer will ask of you.
Next Steps for You Can Take
To take advantage of preferential capital gains tax, you can begin by pulling a recent statement of your investment portfolio from your custodian. They will be tracking your cost basis and gains and losses. You can then determine what your income is likely to be for the year and if it could make sense to harvest any gains or losses.
If you have a life event such as a job loss or are going back to school it can be a good time to review your finances with a professional, such as your financial advisor or CPA. They can help you make an informed decision about your investment portfolio.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at firstname.lastname@example.org or fill out a contact form.
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.