Have you ever heard of capital gains taxes? If you are thinking about investing in real estate in the future, you will need to familiarize yourself with this term. Let’s discuss capital gains taxes and how they can affect you financially below!
What Are Capital Gains Taxes?
Capital gains are the profits from selling an investment like real estate, stocks, mutual funds, or bonds. Capital gains taxes are taxes you pay based on the profit earned from the investment.
These taxes are essential to the tax code and can significantly impact one’s financial situation. They are levied based on the money you made from the sale between when you purchased and sold it. You do not pay capital gains taxes until you sell your investment.
What Is the Difference Between Short and Long-Term Capital Gains?
How much you owe in capital gains taxes depends on whether you have a short-term or long-term gain. Short-term gains are profits earned from the sale of an investment held for one year or less, while long-term gains are profits earned from the sale of an investment held for more than one year.
Short-term capital gains are subject to the same tax as your ordinary income and are based on your tax bracket, ranging from 10% to 37%. However, long-term gains are taxed differently, ranging from 0% to 20%.
What Is Cost Basis?
An essential aspect of capital gains taxes is your “cost basis.” The cost basis is the original price of an asset plus any extra costs like a broker’s commissions or fees.
When you sell your investment, your tax liability is determined by how much you paid for the asset – or your cost basis – and how much your sales price was. So, if your cost basis was $200,000, and you sold the investment for $250,000, you earned $50,000, and your capital gains tax would be based on the $50,000 profit.
What Is a Capital Loss?
Simply put, a capital loss is the opposite of a capital gain. You will encounter a capital loss if you lose money on your investment and sell it for less than your cost basis. A capital loss is realized once the asset sells for less than the original purchase price.
Let’s refer to our previous example to explore capital losses. If you originally paid $200,000 for an asset but later sold it for $150,000, your capital loss would be $50,000.
Capital losses can be used to counterbalance capital gains in the current or future tax years – losses greater than $3,000 can be carried over to the next tax year to counteract capital gains or reduce taxable income.
Are There Ways to Minimize One’s Capital Gains Tax Liability?
Individuals use several strategies to minimize their capital gains tax liability. Here are a few:
1. The first strategy is often called harvesting – an investor "harvests" either their capital gains or losses. When one harvests capital gains, they purposefully wait for years when their income is lower before realizing their gains. People also utilize tax-loss harvesting, which involves selling losing investments to offset gains from other appreciated assets.
2. The second way to minimize tax liability is to hold on to your investment for over one year. Doing so allows you to pay the long-term capital gains tax, which is lower than the short-term capital gains tax.
3. While this may not work for everyone, you can donate your appreciated asset to an heir or charity to decrease your capital gains tax liability.
4. Lastly, certain investments, such as opportunity zone funds and tax-exempt municipal bonds, can be used to minimize or eliminate capital taxes.
Whom Should I Contact With Capital Gains Tax Questions?
We recommend consulting a knowledgeable financial advisor or tax professional before making decisions that may impact your capital gains taxes. They can guide you on the best strategies to minimize tax liability on investment returns.
Final Thoughts
Understanding capital gains taxes is crucial for individuals wanting to make informed decisions about their investments and financial future.
If you have spoken to your financial advisor and are ready to invest in real estate, look no further than your full-time, full-service REALTOR® Liz Kettelle at RE/MAX! Please feel free to send a message or call (401) 823-7701 with questions or for more information.
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