Whenever we add value to a capital asset, making it worth more than the price we bought it for, we become eligible for capital gains tax. This added value becomes realized when we sell the asset. Capital gains tax can be applied to real estate, stocks, bonds and even licenses.
On the other hand, if we sell something for a price lower than the one we bought it for, we find ourselves in a situation called capital loss. Consequently, we can make up for our capital losses in investment A with our capital gains from investment B and the tax system will adapt for it.
Let’s say that we made a capital gain of 50.000$ and a capital loss of 30.000$ on two different investments. The government will tax us only for the 20.000$ from the net result.
However, always keep in mind that capital gains tax depends on how long we have held on to an asset. This means that the tax rate will not be the same for long-term and short-term investments.
With that in mind, let’s start breaking down the capital gains taxes.
Assets Held Less Than One Year
First of all, we should all know by now that short-term investments are the ones we have invested in for less than a year. All income we receive from these investments will be taxed at a higher rate.
Short-term investments are extremely volatile and risky, not to mention that the transaction fees for individual investors are quite high. In order to reduce the number of these types of investments, the government has decided to tax them on a much higher rate.
In 2018, capital gains tax rates for short-term investments were set at 10%, 12%, 22%, 24%, 32%, 35% and 37%.
Ultimately, we can reduce the capital gains tax amount by waiting for our investments to become long-term. We can also reinvest the money we got from dividends into our underperforming investments.
Assets Held More Than One Year but Less Than Five Years
IRS considers every asset that we hold for more than a year to be a long-term investment. Generally speaking, the highest capital gains tax rate is 15% with three exceptions:
- The maximum tax rate for small business stock cannot exceed 28% of the net gain.
- Net capital gain from selling collectibles cannot exceed 28%.
- Any capital gain from selling real property that falls under section 1250 cannot be taxed over 25%.
The IRS clearly favors long-term investments over short-term ones. This is what makes the investors have a buy-and-hold approach and for a very good reason. Long-term investments help stabilize the country’s economy. If the IRS decides to tax long-term investments at a higher rate, we would have a capital flight on our hands.
Ramifications Of Tax Rates On Your Investment Decisions
Let’s imagine two situations.
Situation 1: Say we fall under the 32% tax bracket and want to invest 120,000. After six months we sell our assets for 190,000$ which means that we have acquired a capital gain of 70,000$ with a 58.33% return. Consequently, we have to pay 24,500$ in taxes and end up with the profit of 45,500$.
Situation 2: If we invest 120,000$ in stocks and sell them in the following year for 180,000$ we end up with a capital gain of 60,000$ and a 50% return. However, this is a long-term investment which means that the capital gain tax rate is only 15%. We pay only 900$ in the name of taxes which makes the profit 51,000$.
In short, even though the capital gain was higher in situation 1, the lower tax rate in situation 2 gave as an extra 5000$ profit.
We covered all the basics necessary for making a good choice of longevity concerning our investments. The lesson here is that we shouldn’t be hasty while making a choice between short-term and long-term investments.