Investing in your future is a noble cause. However, it can get confusing especially around tax time. Having a good understanding of the basics of filing your taxes when recording investments can help you to better navigate tax savings. While we can’t explain everything to you all in one article, we’re going to cover the major basics that you’ll want to know.
What are Capital Gains?
When you start to read about any sort of taxes for investors, especially those in real estate, you’ll hear the term capital gains over and over again. This should symbolize its importance in your tax filings. Capital gains is a tax imposed by the federal government that is levied on the profit that you make from selling a property or investment.
Realize the term ‘profit’ was included. This means that the sale price was higher than the purchase price of the stock, bond, property, or another asset. Only when the sale price is higher than the initial purchase price is the capital gains tax imposed. If the sale price is lower than the asset’s purchase price, it’s considered a capital loss and there is no federal tax imposed on the sale of the asset.
In today’s society, people tend to find various ways to defer taxes on capital gains, which may reduce their tax liability. One of the ways to defer taxes on capital gains is to reinvest the profits from the sale of the capital asset into a dst 1031 Exchange. A 1031 exchange is a transaction that allows an investor to defer capital gains taxes on the sale of an asset by reinvesting the proceeds into a similar asset. This is commonly used in real estate investments and can be an effective tool for investors. Another way to defer taxes on capital gains is to invest in Qualified Opportunity Zones (QOZs). The deferral of capital gains occurs when the proceeds from the sale of the capital asset are reinvested into a QOZ fund.
Long vs. Short Capital Gains
When discussing capital gains, there are two different types. These include short-term and long-term gains. You’ll want to understand each type of capital gains so that you can talk turkey with tax preparers and financial advisors. Let’s take a look at the variances between the two types of capital gains below.
Short-Term Capital Gains
These are gains that are received from an asset that has been owned for one year or less. This type of gain is taxed as ordinary income. That means that you simply include it to your other income and tax it at your regular income bracket.
Long-Term Capital Gains
These are gains that are received from an asset that has been held for more than one year. These types of capital gains have their own tax brackets. Their rates are much lower than short term gains. This is set in place by the federal government as a way to encourage investors to hang onto their investments for the long-term.
The price differences in tax brackets are major between these two types of gains. To help you understand the impact of long-term vs short-term capital gains, let’s go over a simple example. This will share with you just how much of a difference in tax break you can get from the long-term investment.
Let’s start with the assumption that you make $40,000 per year and your capital gains are $5,000. With short-term capital gains tax, your $5,000 would be included with your $40,000 income to be taxed as ordinary income. This $45,000 will put you in the 22 percent tax bracket. This means paying a tax liability of $1,100 on your $5,000 capital gains.
Now, assuming the same base assumptions, we’re going to look at this from the long-term capital gains standpoint. Since you held the asset for over a year before selling, your capital gains of $5,000 are taxed in its own capital gains special long-term tax bracket. This bracket is 15 percent which equates to a total tax liability of $750. Comparing this long-term tax liability with the short-term gains tax liability, you’ll save yourself $350.
As you have learned, there’s a lot to understand about tax filings for an investor. While it’s almost impossible to know every tax law regarding investments, it can be very helpful for you to understand the basics. This will give you some good footing to talk with an experienced tax professional when doing your own taxes.