When a taxpayer buys and then sells a piece of property for a gain, the difference between the cost basis and the selling price is a capital gain. It is taxed as income under the Internal Revenue Code. However, because the types of items normally affected by the Capital Gains Tax are often related to behaviors that the government wants to encourage, such as homeownership and investing in businesses, the tax rate is often adjusted to try to reward certain types of investments by reducing the rate at which those investments are taxed. The following is a brief overview of the capital gains tax.
How a capital gain is treated depends on what the item was and how long it was owned by the taxpayer. The simplest is the short term gain rate, which applies to any gain on a piece of property held for one year or less. These short term gains are taxed at the taxpayer’s normal income tax rate, or the ordinary income rate. Currently, that means that the short term holdings are taxed at one of six rates: 10%, 15%, 25%, 28%, 33%, or 35%. And it also means that for taxpayers whose taxable income is zero, the capital gains tax is also zero.
For taxes on property held more than one year, the rates will depend on the type of item being sold. If the item is anything other than real estate, collectibles, and certain small business stock, the long term rate is 15% for taxpayers who are in the top four tax brackets (25% to 35%) and is zero if taxpayers in the bottom two tax brackets. This gives every tax bracket a break of between 10% and 20% between how long term gains are taxed relative to ordinary income.
For capital gains on collectibles and certain small business stocks, the long term capital gains rate is taxed at the ordinary income rate up until the 28% bracket. For taxpayers in the brackets higher than that, the rate caps out at 28%. So taxpayers in the 33% and 35% brackets receive a slight discount relative to their ordinary rate. The same applies for long term gains on real estate, except that the long term gain rate tops out at 25%.
There are three major exceptions to the capital gains tax structure described so far. First, taxpayers can defer capital gains on certain investment properties by making a like-kind exchange and rolling the capital gain into a new property. For qualified transfers, this device (named a 1031 exchange after the section of the Internal Revenue Code that authorizes it) allows gains to accumulate as long as the property is continuing to be used for investment purposes and as long as the new property is of the same variety as the old one.
Second, taxpayers can exclude much of the gain on the sale of a primary residence. The taxpayer had to live in the home for 2 of the 5 years prior to the sale, and can only exclude up to $250,000 (or $500,000 for married taxpayers who file jointly). But for the average homeowner, whose home represents one of the biggest investments he or she has, this exemption provides for a major tax break on a home that has appreciated over time.
Third, certain investments in small business are exempt from the capital gains tax in an effort to encourage venture capital and so-called angel investors to keep investing in the economy. This exemption is temporary, being re-enacted occasionally to attempt to encourage economic growth.
The capital gains tax is one of the more complex areas of tax law, because the rates at which capital gains are taxed can vary substantially depending on what the property was and how long it was held, navigating the tax consequences of property sales can be tricky. For major property, an accountant or tax lawyer can help, and for smaller amounts commercial tax preparation software often covers all the bases.