When it comes to your taxes, it's important to understand the impact of long-term vs short-term capital gains tax. This distinction is key because the Internal Revenue Service taxes each type of income at different rates.
Certain types of capital gains, such as those from the sale of stock or mutual funds you have had for a long period of time, will be generally taxed more favorably than your interest income or salary. Yet, not all capital gains are taxed the same.
As we previously mentioned, the long-term vs short-term term capital gains rates can be dramatically different. Let's take a closer look at long-term vs short-term capital gains tax and income tax rates.
What Is Capital Gains?
Capital gains are those profits that you earn from selling real estate or an asset such as stock. Typical capital assets include cars, land, businesses, boats, etc. Anytime you sell one of these assets at a profit — more than you paid for it — it can trigger a taxable event for that tax year.
The profit will not be taxed as ordinary income, and you'll need to pay capital gains tax rates. This means you'll need to report the asset differently on your income tax return.
Long-Term Net Capital Gains vs Short-Term Net Capital Gains
For the most part, capital gains will be taxed based on how long you have held the asset. This time span is recognized as the holding period. Any profits you make from selling an asset that you have held onto for less than a year will be categorized as short-term capital gains.
On the other hand, profits you've earned from assets that you have held on for a period longer than a year — such as selling a home — will be classified as long-term capital gains. Generally, there are different tax rates and specific rules that are applied to each type of capital gain. Typically, you will pay more in taxes on short-term capital gains than you will on long-term capital gains.
Overview of 2020 Short-Term Capital Gains Tax
Most businesses and taxpayers will not enjoy any type of special tax rate on taxable income from the short-term sale of an asset. On the contrary, these assets will be taxed at your normal tax bracket.
Your tax bracket will be based on your filing status and income. A few key points about short-term capital gains include:
- Based on your filing status and income, the standard tax rates for 2020 range from 10% up to 37%.
- The holding period starts from the day you purchase the asset up to the day you sell it.
Overview of 2020 Long-Term Capital Gains Tax
When you hold onto an asset for a period longer than a year, you may enjoy a reduced tax rate on the profits generated from the sale. In fact, people who are in a lower tax bracket could pay nothing in the capital gains tax rate.
On the other hand, those who are in a higher tax bracket could save as much as 17% off the standard income rate based on data from the Internal Revenue Service.
Are there Exceptions to the Long-Term Capital Gains Tax Rules?
As with most rules, there are exceptions to the long-term capital gains tax rate.
One significant exception to the reduction in the tax rate associated with long-term capital gains involves collectible assets, such as:
Largely, profits from the sale of these types of items will be taxed at 28% — irrespective of how long you have had the items.
The Net Investment Income Tax
Another key exception to the capital gains tax rate rule for long-term investments is with the Net Investment Income Tax (NIIT). The NIIT adds an additional 3.8% tax to specific net investments of individuals, trusts, and estates above a threshold.
The NIIT usually applies to those who have high incomes and generate a substantial amount of tax from dividend income, investments, and interest.
Ways to Strategically Minimize Capital Gains Tax
When it comes to your taxable income, it's best to work with an experienced accountant at John F. Dennehy. We utilize our extensive understanding of complex tax codes to help minimize your liability and advise you on the best path forward. In either case, some of the most common ways to minimize the amount of taxes you'll pay on capital gains are listed below.
Choose Tax-Deferred or Tax-Free Investment Vehicles
When you invest in tax-free or tax-deferred investments like 529 college savings plans, 401(k) plans, and Roth IRA accounts, you may create substantial savings in your taxes. This is due to the fact that these investments are allowed to grow either tax-deferred or tax-free, which means you will not have to pay capital gains taxes on your earnings immediately.
In certain circumstances, you may be able to completely circumvent taxes when you take money out of the account.
Hold Onto Assets for As Long As Possible
Keeping your assets past the one-year threshold is one of the most obvious ways to reduce your capital gains taxes. Because short-term capital gains can be taxed at a higher rate than long-term capital gains, keeping the asset for more than a year can help you pay a lower capital gains rate on your profits.
Don't Sell the Property Too Quickly
Another significant exception to the capital gains tax rate rule is real estate profits from your primary or principal residence. If you own a home and utilize it as your primary residence for a minimum of two of the five years before you sell it, you can typically exclude up to $250k of the capital gains on the sale of the asset if you are single.
On the other hand, those who are married and filing jointly can exclude up to $500k. However, you can't exclude several sales of properties from capital gains taxes within a two-year period.
Contact John F. Dennehy CPA
Navigating the arena of long-term vs short-term capital gains taxes can be confusing. Fortunately, you don't have to do it alone. The team at John F. Dennehy CPA can help. We offer exclusive experience helping business owners, individuals, real estate investors and more minimize the tax liability from the sale of assets.
Contact John. F Dennehy CPA today.