When you start digging into the tax code – not something we’d recommend unless you are suffering from severe insomnia – you’ll quickly notice that there are a seemingly endless number of taxes.
Fortunately, many of these taxes are highly specialized and don’t affect most people. However, some of these taxes occasionally pop up in media stories, which can lead to confusion.
You have probably heard of the capital gains tax somewhere, but if you don’t know what it is or if it will affect you, you’re not alone. In this article, we’ll provide a quick review of the capital gains tax and explain why it’s something you probably don’t have to worry about.
Understanding a Capital Gain
Simply put, a capital gain, is the positive difference between the purchase price of an asset and its selling price. So, for example, let’s say that you purchased a piece of art by an unknown artist for $100. Over the next five years, the artist shot to fame, and the little portrait hanging over your mantel is now worth $10,000. Good job! If you sell the artwork, your capital gain will be $9,900.
You can earn capital gains on almost anything, but the most common items are the sale of property (like your home), a business, stocks and mutual funds, and collectibles. It should be noted that if you lose money, that is considered a loss, not a capital gain.
It shouldn’t surprise you that the IRS isn’t about to let you pocket all that sweet profit without taking its cut, which leads us to the capital gains tax.
Taking Its Share
The government has a special tax that it places on all capital gains. It is creatively called the capital gains tax. Now, before you begin freaking out about selling your house in the near future, there are two reasons that you really shouldn’t worry about the capital gains tax.
The first reason is that the capital gains tax rate is actually lower than the income tax rate. For example, the highest amount of capital gains tax that you can possibly pay is 28%, while the highest income tax rate is 39.6%. The amount of capital gains tax you will pay depends on what type of asset you are selling and your income.
The lower your income, the lower the rate of capital gains tax you will have to pay. In fact, if you pay 15% income tax or less, you don’t have to pay any capital gains tax at all on most assets, including real estate and most kinds of stocks.
Selling Real Estate
The second reason you shouldn’t worry about capital gains tax is that 99% of homeowners don’t have to pay it when they sell their homes. Many Americans only encounter a capital gain when they sell their home. Setting aside the housing bubble crisis, home prices tend to rise over time, which means that if you’ve lived in your house for several years, chances are you can sell it for a profit and recognize a capital gain.
Fortunately, there is a very sweet exemption in the capital gains tax law. If you are selling your primary residence, then you can enjoy a capital gains exemption of $250,000 as an individual or $500,000 as a couple.
That means as long as you don’t earn a profit of over $250,000 / $500,000, you won’t have to pay any taxes on your capital gains. As if that weren’t nice enough, you can often deduct money you spent on improving or fixing the home from your capital gains calculation.
Of course, there are some caveats. In order to receive the capital gains tax exemption, you must have lived in your home for at least two of the last five years before you sell. Also, as mentioned, this must be your primary residence. If you sell your vacation home or rental property at a profit, then you’ll have to pay a capital gains tax.
When Should You Worry About Capital Gains?
There are a few instances when you may need to pay capital gains taxes. As we just saw, you’ll have to pay capital gains taxes on profit you earn by selling any property that is not your primary residence. If you are a business owner, you may get hit with capital gains on your business sale.
Stocks within a retirement account are usually safe from the capital gain tax, but earnings on stocks and mutual funds within your normal investment portfolio will likely get hit with capital gains taxes when you sell them.
If you buy and sell your stocks too quickly, you could be looking at higher taxes. (Learn more about paying taxes on investment gains.)
Want to learn more about taxes? Take a look at our taxes article archive or increase your financial IQ by starting a Money Club.