Capital Gains Tax: What It Is and How to Minimize It

A capital gains tax is a tax on the profit of an investment when an investor sells that investment. For example, if you bought a share of stock at $50 and you then sold it later for $100, you would have a capital gain. A capital gain is the difference between the original purchase price of an investment, and the sales price of the investment.

The capital gain dollar amount is what is subject to a capital gain tax. In the example above, you would have a capital gain (or profit) of $50. This $50 profit that you made when you sold your investment would be subject to a capital gains tax.

Capital gains tax only apply to profitable investment sales. For example, say that you bought a share of a stock at $50 and then sold it at a loss for $40. Since you lost money, you would not owe capital gains tax.

The first step to calculating capital gains taxes is to figure out how much profit you made when you sold an asset. You can do this by subtracting your basis from your sales price. Your basis is the original purchase price of the asset plus any fees or commissions that you paid.

Your sales price is the price you sold the asset at minus any fees or commissions that you paid. For example, say that you bought a share of an index fund for $200 and did not pay any commission or fees. You then sold that share later at a price of $300 and did not pay any commissions or fees.

You would subtract the basis of $200 from the selling price of $300 to determine your profit which would be $100. This $100 would be subject to capital gains tax. After you have calculated your profit, you then need to determine if you will be paying a short or long term capital gains tax.

A short term capital gains tax is applied when you hold an asset for a year or less before selling. A long term capital gains tax is applied when you hold an asset for more than a year before selling. The short term capital gains rate is the same as your income.

For example, say that your income puts your tax rate at 25%. If you held the index fund in the example above for less than a year before selling, a short term capital gains tax would be applied. Since the profit was $100 from the sale, you would owe $25 (a 25% tax rate) in capital gain taxes.

However, if you held the index fund for more than a year before selling, a long term capital gains tax would be applied. Long term capital gains rates are 0%, 15%, or 20% depending on your income and tax filing status. You can use the chart below to assess what your long term capital gains tax rate would be. (Accurate for 2024)

Simply find your tax filing status and corresponding range of income. For example, if your income was $100,000 and your tax filing status was single, your long term capital gains tax rate would be 15%. This means you would owe $15 (15% tax rate) on your $100 profit from the sale of the share of your index fund.

1) Stocks, index funds, mutual funds, ETFs - Individual stocks or investment funds, such as index funds, mutual funds, and ETFs that hold stocks, are subject to the standard capital gains tax rules discussed above. If you hold these assets for less than a year before selling, a short term capital gains tax is applied. If you hold these assets for more than a year before selling, a long term capital gains tax is applied.  

2) Bonds - If you sell a bond for a profit, you have created a capital gain and will be taxed at either a short or long term capital gains tax rate depending on how long you owned the bond. However, bonds also pay out interest.

The interest that you receive can be subject to taxes depending on the type of bond. The interest you receive is taxed at the same rate as your ordinary income. Capital gains taxes only apply to the profitable sale of a bond, as the taxation of the interest is not a capital gains tax.

3) Real estate - Your primary residence is subject to the standard capital gains tax rules. If you sell your home for a profit, you will be subject to short or long term capital gains tax depending upon how long you owned your home before selling it.  

However, the IRS does offer a home sale tax exemption if it is your primary residence. The IRS allows you to exclude $250,000 or $500,000 (if you are married) of capital gains from the sale of a primary residence. For example, say that you were married and bought a home for $500,000. If you sold that home for $ 1 million ten years later, you and your spouse would not owe any capital gains tax due to the exemption.

In order to use this rule the home must be your primary residence, you must have owned the home for 2 years, you must have lived in the home for at least 2 years in the past 5 years before you sold it, and cannot have used the exemption recently on another home.

Real estate rental properties are also subject to short or long term capital gains tax if you sell the property for a profit. Rental properties do not qualify for the home sale tax exemption rule as they are not a primary residence.

However, real estate investors can use a 1031 exchange to defer paying capital gains tax. A 1031 exchange allows you to use the proceeds of the sale of an investment property to buy another investment property that is like the one you sold.  

A 1031 exchange does not help you avoid paying capital gains taxes. It instead defers paying capital gains taxes. The idea is to wait to pay the capital gains tax until later. To use this strategy you must have a new rental property lined up within 45 days and complete the closing of the new property within 180 days.

If you do not meet these deadlines, you will owe capital gains taxes on the original sale of the first rental property. In addition to capital gains taxes, the income that rental properties produce is also subject to tax. The income that rental properties produce is taxed at the same rate as your ordinary income.  

However, real estate investors often take deductions allowed by the IRS to reduce or eliminate the amount of tax they owe from the income a rental property generates. Investors are allowed to deduct depreciation, maintenance costs, and repairs.

4) Cryptocurrency - Cryptocurrency is subject to the standard capital gains tax rules discussed above. If you hold crypto for less than a year before selling, a short term capital gains tax is applied. If you hold crypto for more than a year before selling, a long term capital gains tax is applied.  

5) Precious metals - Physical holdings of precious metals such as gold and silver are subject to a modified capital gains tax. Short term capital gains on precious metals are taxed at ordinary income rates. Long term capital gains on precious metals are taxed at marginal tax rates with a maximum tax of 28%.

For example, say that an investor owned physical gold and sold it after holding it for 5 years. The profit from this sale would trigger a long term capital gains tax. If the investor were in the 35% tax bracket, they would only owe 28% in capital gains taxes.

6) Collectibles - Collectibles are considered capital assets and are therefore subject to capital gains tax. Collectibles can include rare pieces of art, expensive bottles of alcohol, gems, stamps, coins, and more. Short term capital gains on collectibles are taxed at ordinary income rates.

Long term capital gains on collectibles are taxed at marginal tax rates with a maximum tax of 28%. For example, say that an investor bought a bottle of wine for $30,000 and sold it two years later for $50,000. This would trigger a long term capital gains tax. The maximum tax this investor would pay would be 28% even if their tax rate were higher.

When you invest, you can take advantage of tax advantaged investing accounts. These investing accounts have special tax benefits associated with them. These accounts are not investments themselves but hold your investments. There are two main types of tax advantaged investing accounts.

a) Tax deferred accounts - A tax deferred account allows you to "defer" your tax bill until later. Two common tax deferred accounts are the 401k, which is a retirement plan offered by employers, and the Traditional IRA, which is a retirement account you can hold outside of work.

When you contribute money to buy investments through these accounts, you get a tax break up front. 401k contributions are tax deductible and Traditional IRA contributions may be tax deductible. For example, say that you make $80,000 per year and contributed $5,000 to your employer's 401k plan.

You can deduct this $5,000 which means your taxable income would go from $80,000 to $75,000. When you use these accounts, all the investments within the account grow tax deferred. This means that you will not have to pay any taxes on the money as you invest.

Once you retire, you can start to pull the money out of these accounts as long as you follow the withdrawal rules. At this point, you will have to pay taxes on the money you withdraw. Remember, you got a tax break up front and then waited to pay taxes. When you retire, you will owe taxes.

The advantage to using a tax deferred account is that you wait to pay taxes until you retire. If you believe that you will owe less taxes in the future than you will today, it can be beneficial to use one of these accounts as you wait to pay taxes until they are lower for you.

b) Tax free accounts - Tax free accounts work in the opposite way of tax deferred accounts. Instead of waiting to pay taxes until later, you pay taxes up front. However, all the money that you contribute to the account grows tax free and when you pull the money out you pay no tax.

Two common tax free accounts are the Roth 401k and Roth IRA. When you contribute to these accounts, you do not get to deduct the contributions from your taxable income. However, all the investments grow tax free in the account.

This means that you will not owe any taxes on the growth of the investments within the account. Additionally, when you pull the money out of the account, you will not have to pay any taxes. If you believe that taxes will be higher in the future, it can make sense to use a tax free investing account.

You do not get an upfront tax benefit, but you get tax benefits on the growth of your investments and the withdrawals you take. The idea is to pay taxes on the dollars you contribute upfront, but then enjoy a tax free retirement.  

Beyond tax advantaged investing accounts, the easiest way to reduce capital gains tax is to wait longer than a year before selling your investments. Long term capital gains rates are often lower than short term capital gains rates especially if your ordinary tax rate is above 20%.

For example, say that your ordinary income tax rate was around 30%. If you were to buy index funds through a taxable investing account, such as a brokerage account, and then sell those index funds less than a year later, you would owe short term capital gains tax.

This means that your profits would be taxed at 30%. However, if you simply waited for more than a year before selling, you would be taxed at long term capital gains rates. This might mean that you only owe 15% in capital gains tax on your profits.

Thirdly, you can use capital losses to offset capital gains. Capital losses are when you sell an investment at a loss as opposed to a gain. You can subtract the losses from your gains to lower the amount of money that is subject to capital gains tax.

For example, say that you owned two mutual funds within a taxable investment account. You sold one mutual fund for a $5,000 gain and the other mutual fund for a $2,000 loss. You can subtract this $2,000 loss from the $5,000 gain.

This would leave you with $3,000. You would only owe capital gains tax on $3,000 as opposed to owing capital gains tax on $5,000. If your capital losses exceed your capital gains, you can use those losses to offset your ordinary income up to $3,000.

The IRS allows certain exclusions related to capital gains tax. The most common of these is the home sale exclusion. If you follow the IRS rules, you can use this exclusion to exclude $250,000 or $500,000 of the capital gain because of selling your primary residence.

Navigating how to reduce capital gains tax is no easy feat. The best strategy to learn how to reduce your capital gains tax is to work with financial experts. This might include hiring a financial advisor and accountant. Not only can these individuals help you reduce your capital gains tax, but they can also assist you in creating a comprehensive financial plan that is right for you.

The bottom line is that a capital gains tax is a tax on the profit of the sale of an investment. If you hold an investment for a year or less before selling, you will owe short term capital gains tax. If you hold an investment for longer than a year, you will owe long term capital gains tax.

You can reduce your capital gains taxes by using tax advantaged investing accounts, waiting for longer than a year before selling, using capital losses to offset capital gains, looking for exclusions, and working with financial experts such as financial advisors and accountants.