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How do Capital Gains Affect My Taxable Income?

Classic investments, like stocks, are not the only investments taxed by capital gains. Capital gains taxes can apply to any other property that acquires value over time. Buying and selling things like real estate, collectibles, precious metals, etc. can all generate capital gains. These taxes are calculated by subtracting the cost of the investment from the final selling price of said investment. This final amount is reported as capital gains. But, the final amount can be taxed at different rates depending on the investment type, earned income of the owner, and other unique stipulations.

Below we’re reviewing how capital gains taxes are determined and how they affect other areas of your financial plan come tax time.

Capital Gains Tax Rates

The total tax amount will depend on a variety of factors....most notably by the type of asset being sold. Traditional investment assets such as real estate, stocks, cars, boats, etc. are all taxed at short-term or long-term capital gains rates. Other "collectible" items such as art, antiques, precious metals, and things of that nature are typically taxed at a flat long-term rate of 28%, or as ordinary income if sold less than a year from date of initial purchase.

Here are how long-term capital gains are taxed at various income levels. Remember, to qualify for long-term status, the asset must be held for at least 1 year from the original date of acquisition.

  • A total earned income of less than $80,000 for taxpayers filing jointly or $40,000 for single filers can allow realization of long-term capital gains at zero percent
  • A rate of 15 percent is set if your income is between $80,000 and $441,450 for 2020, but this range will change depending on your marriage filing status.
  • Capital gains rates jump to 20% for those with income above the $441,451 mark
  • In addition to each of these three rates, a surcharge tax of 3.8% is applied for those single filers earning above $200,000 or for joint filers earning above $250,000

Make sure to check with the IRS or your accountant to best understand how different investments are taxed. 

Do Capital Gains Impact Other Areas of Planning?

In its simplest form, yes! Unfortunately capital gains (long and short term) are not counted as earned income in determining which tax bracket you fall into, but they DO count towards the determination of Adjusted Gross Income (AGI). Why is this important? Here are a few scenarios below:

  • AGI is the determinant for a lot of retirement plan contributions. For instance, your eligibility to contribute to things such as Roth IRA accounts will be affected by your AGI.
  • The government used AGI this past year as a basis for qualification of stimulus payments and other tax benefits. If your tax return included substantial capital gains from the sale of a rental property, for instance, your qualification status for these benefits would likely have been affected.
  • AGI limits also determine qualification for tax credits such as the American Opportunity Tax Credit. If paying for a dependent's college tuition, this could be an opportunity lost as a result of mistiming the sale of an asset that generates an unexpected capital gain.

These are just a few examples of how capital gains need to be properly considered before the sale of an asset such as a business or real estate. 

Are the certain planning techniques that should be considered with regards to the timing of realization of capital gains? Absolutely! Let's explore some.

Offsetting Capital Gains

Investments may not always pay off. Sometimes a market change results in your property reducing in value. This reduction is also calculated on your taxes and is calculated into your capital gains taxes. This can lower your taxable income range.

For example, if you earned $1000,000 from income in a given year and then sold an investment with a $10,000 gain, your investment gain would be taxed at the 15 percent rate. However, if you lost $15,000 on another investment and decided to sell this investment at a loss, this could offset your gain and generate a capital loss that could be claimed or, in some cases, carried forward to a future tax year.

There are some other nuances to offsetting short and long-term gains, but this is why you can rely on a tax professional or advisor with a tax planning focus to help with these issues and ensure the most advantageous strategies are being used when considering the sale of your investments.

Like-Kind Exchanges

Capital gains taxes can be postponed by using the income to invest in a similar property type. However, make sure to consult the IRS website or your tax professional before moving forward on any like-kind exchange, as the requirements and investment types have changed over the years. Real estate, insurance and annuity products, and even equities and be sold and repurchased in like-kind exchanges to defer the capital gains on the original investment to some future date.

Sometimes it makes sense to realize these gains. Sometimes it makes sense to enact these types of like-kind exchanges. This all depends on circumstances such as earned income in a given year, planning objectives, and liquidity needs.

Step-Up in Basis

At death, some investments, real estate, and other qualifying investments are eligible to receive a step-up in basis. At the death of the owner, a beneficiary of the investment will automatically receive a new basis at the value of the investment from the date he or she inherited this property from the deceased owner. This is an important consideration when planning a strategy for estate planning and income planning in retirement.

Keep in mind, there has been some conversation about eliminating this provision with the new Biden administration. We are keeping an eye on this potential legislation as it would dramatically change the way planning is conducted in the future.

As you can probably tell, capital gains can be quite complex. There are a lot of nuances to selling investments that can impact wealth in a given year or over the lifetime of a financial plan. It's important to consider everything before deciding to liquidate an investment or an asset. As always, we're here to help! Schedule some time and we'd love to connect to discuss your unique situation and help craft a plan for you.