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What Is Capital Gains Tax?

If you’ve spent any time hanging out with investors or accountants, the term capital gains tax has probably come up once or twice. More than likely you have a good idea of what income taxes are—the money Uncle Sam takes out of your paycheck every couple of weeks—but what are capital gains? What are capital gains taxes?

What Are Capital Gains?

When you sell an asset, like a share of stock or a piece of property, and it sells for more money than you originally purchased it for, the extra money or profit you earned goes by another fancy name in the tax world: capital gain. And guess what? The government claims a slice of that profit by charging a capital gains tax—simply because, well, it’s the government. Cue eye roll.

How Does Capital Gains Tax Work?

Let’s say you buy a piece of land for $25,000. Later, you sell that same piece of land for $75,000. The profit you make—in this case, $50,000—is a capital gain. You bought an asset, the asset increased in value, and you sold it for more than you paid for it. Easy, right?

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Next, that profit gets taxed by the IRS. And the amount of tax you have to pay on it is determined by a few different factors, which gets pretty complicated. But hang with us and we’ll guide you through it.

How Much Is Capital Gains Tax?

Depending on how long you own the asset in question, and in some cases, what kind of asset you own that’s gone up in value, it may be taxed at a different rate—or it could be exempt from taxes altogether.

That’s because long-term capital gains and short-term capital gains are taxed at different rates, and some capital gains are exempt up to a certain amount. (There’s always a magic number.)

Let’s take a closer look!

Long-Term Capital Gains Tax

If you buy something—let’s say it’s a share of stock—keep it for at least one year, and then sell it for more than you originally bought it for, that’s a long-term capital gain.

Long-term capital gains are taxed at special rates—starting at 0% (meaning you don’t owe any taxes) and maxing out at 20%—based on your taxable income. Here’s a look at the 2020 tax brackets:

2020 Long-Term Capital Gains Tax Rates

Rate

Single

Married

Head of household

Married filing separately

0%

$0–40,000

$0–80,000

$0–53,600

$0–40,000

15%

$40,001–441,450

$80,001–496,600

$53,601–469,050

$40,001–248,300

20%

Over $441,450

Over $496,600

Over $469,050

Over $248,3001

 

The tax brackets for 2021 break down like this:

2021 Long-Term Capital Gains Tax Rates

Rate

Single

Married

Head of household

Married filing separately

0%

$0–40,400

$0–80,800

$0–54,100

$0–40,400

15%

$40,401–445,850

$80,801–501,600

$54,101–473,750

$40,401–250,800

20%

Over $445,850

Over $501,600

Over $473,750

Over $250,8002

 

There is also a separate, Net Investment Income Tax (NIIT) of 3.8% that is charged on capital gains for people whose Modified Adjusted Gross Income (MAGI) is over $200,000 ($250,000 for married filers).3 This amount doesn’t change with inflation.

If you sell your house, that’s also a capital gain, but depending on how long you’ve lived there your profit may actually be tax-exempt. Here’s the thing: It has to be your main residence (where you live full-time, not the lake house), and you have to have lived in the house for at least two years of the previous five to exempt up to $250,000 in home sale profit (this goes up to $500,000 for married couples).4 This means you don’t pay any taxes on it, capital gains or otherwise! That’s awesome! You can claim this exemption once every two years.

Short-Term Capital Gains Tax

Short-term capital gains are taxed differently than long-term capital gains. If you’ve owned the asset in question for less than one year (think: house flip), the profit from the sale is taxed at your normal, personal income tax rate.

When you file your taxes, all you need to do is check your federal income tax rate to see how much you owe in taxes for your short-term capital gain. It’s also important to note that the NIIT of 3.8% also applies to short-term capital gains.

How to Avoid Capital Gains Tax

Great news! There are ways to avoid being taxed on your capital gains. But you’ll need to have a plan set in place before you purchase or sell an asset. For example, if you purchase assets through a qualified retirement account like a 401(k) or a Roth IRA, you won’t have to pay any capital gains taxes at all—woo-hoo!

On the other hand, if your asset is a rental property, you can defer or postpone paying capital gains tax by taking advantage of a 1031 exchange. This tax-deferred rule allows you to sell a property and reinvest the profit into what the IRS calls a “like-kind” investment.

Here’s how a 1031 exchange works: Soon after selling your rental property, you use the profit to purchase another similar property and—ta-da!—you won’t have to pay capital gains tax until you stop reinvesting your profits. But you better hurry! You only have a short window of time to reinvest the money in order to avoid the capital gains tax.5

Make Your Tax Journey Easier

This is a lot to keep track of, but a tax pro can help you crunch these numbers with no sweat. Our tax Endorsed Local Providers (ELPs) are great at helping people figure out what to do come tax time.

Not only will they help you prepare your return, but our ELPs will also help you plan for the future. They’ll walk you through your withholdings to make sure you’re getting the biggest possible paycheck while not also getting stuck with an unexpected tax bill come April.

Find your tax pro today!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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