Capital gains tax guide: everything you need to know about capital gains

A capital gain is an increase in the value of an asset or investment above what you paid. Capital gains occur when investments such as stocks, bonds, and property are sold for more than their purchase price.

Capital gains are divided into two types based on how long you owned the asset.

• Short-term capital gains tax rates apply to assets owned for less than one year. The short-term capital gains tax rate is typically the same as rates on ordinary income such as wages.

• Long-term capital gains tax rates apply to assets held for at least one year. Long-term tax rates on capital gains are determined based on your income and filing status. The federal long-term capital gains tax could be 0, 15, or 20 percent. Long-term capital gains tax rates are more favorable than ordinary income tax rates.

The amount of capital gains tax you owe is determined by your income and filing status on your federal income tax return. However, you may be surprised to learn that you also owe capital gains taxes to the state. Depending on your state, capital gains tax treatment and rates can be vastly different.

Many states charge the same tax rate on capital gains as ordinary income. For example, you could pay up to 13.3% in capital gains tax if you live in California. Other states charge different rates for capital gains and ordinary income. While Massachusetts typically charges a 5% flat tax on long-term capital gains, some capital gains are taxed at 12%. In Montana, you’ll pay a capital gains tax of 6.9%, but you can offset this with a 2% capital gains tax credit.

Capital gains add complexity to your tax returns, but a financial advisor can help you navigate these sticky situations. A good financial advisor can help analyze your tax liability and design a strategy to reduce the impact of capital gains on your federal and state tax returns.

Not all asset disposals are entitled to taxation at a capital gains rate that may be lower than ordinary income rates. Eligible capital assets include:

• Stocks

• Bonds

• Cryptocurrency

• Vehicles

• Collectibles

• Fine art

• Homes and furnishings

• Timber

Short-term capital gains are profits from selling assets owned for less than a year. Short-term capital gains are taxed at the same federal rate as income.

Suppose you’re a single filer earning a total of $80,000 per year, which means you’re in the 22% tax bracket based on your income. Any of your short-term capital gains are subject to this tax rate of 22%. If you have $5,000 in short-term capital gains, you’ll pay 22% x $5,000 = $1,100 in capital gains tax federally, and potentially more depending on your state.

Long-term capital gains are profits from selling assets owned for more than a year. Federal long-term capital gains are usually taxed at rates lower than what you’d pay on your income.

Using the previous example, a single filer making $80,000 reaches the 22% tax bracket for their income. If they generated a $5,000 profit on assets held for more than one year, such as stock investments, the taxpayer realizes a long-term capital gain. Based on the table above, their long-term capital gains are taxed at 15%. The taxpayer owes 15% x $5,000 = $750 in capital gains tax federally, and potentially more depending on their state.

Although federal tax rates are the same regardless of where you live, each state follows its own tax rules. Many states tax short-term and long-term capital gains as income. However, a handful of states offer special tax treatment for capital gains, such as deductions or credits. Some residents are subject to both state and local taxes. At this article’s time of writing, the states with some of the highest capital gains tax rates include:

• California: 13.3%

• New Jersey: 10.75%

• Oregon: 9.9%

• Minnesota: 9.53%

• New York: 8.82%

• Iowa: 8.53%

• Hawaii: 7.25%

Vermont’s capital gains tax rate can be as high as 8.7%. However, the state lets you deduct up to 40% of your capital gains if you’ve held the assets for over three years. The deduction is limited to $350,000 and can’t exceed 40% of your federal taxable income.

Wisconsin’s capital gains tax rates can reach 7.65% but taxpayers can apply for a deduction of 30% of their capital gains (or 60% on capital gains from the sale of farm assets).

Montana taxes capital gains at the same rate as state income, but taxpayers may take a 2% capital gains tax credit. Some states, like Florida and Tennessee, do not charge state income or capital gains tax.

A handful of states do not tax your income, including capital gains. These states include:

• Alaska

• Florida

• Nevada

• South Dakota

• Tennessee

• Texas

• Wyoming

While New Hampshire does not charge tax on personal income or capital gains, it’s important to note that state tax will be paid on any interest or dividends earned. Indiana is at the lowest of the states where you could be taxed on capital gains, with a flat tax rate of 3.23% on all income.

Investments and taxes are unavoidably linked to each other. Tax preparers can help you navigate tax law changes and deductions, but taxes are only part of your financial situation. If you have separate advisors, including a CPA and financial planner, they can all coordinate the best strategy for your personal financial needs.

You might be wondering how to avoid capital gains tax because it can significantly impact your tax liability. A bit of advanced planning with a financial advisor can prevent a surprise tax bill.

Applying the following strategies can help you avoid taxes on capital gains:

• Contribute to your retirement account. You can buy and sell stocks within your retirement portfolio without triggering capital gains taxes.

• Lower your tax bracket. If your ordinary income is low enough, you may avoid paying long-term capital gains taxes. To help drop your income, consider bumping up your charitable donations, increasing contributions to your retirement account, or pre-paying property taxes before December 31.

• Move to a tax-friendly state. You can avoid paying state-imposed capital gains taxes when you relocate to a state that charges minimal tax. Not only can moving to a tax-friendly state save capital gains taxes, but you keep more of your money because you don’t pay a state income tax.

• Donate stock. If you own appreciated stock, you can avoid paying capital gains tax on any profit when you transfer the shares directly to the charity. As an added plus, you can take a charitable deduction based on the current value of the shares, not what you paid for them. The charity gets funding, and you lower your taxes.

Being proactive with your portfolio can help reduce your capital gains tax bill. A financial advisor can show you how to reduce capital gains tax with a few strategies: 

Focus on the long-term

A common way to reduce your tax bill is to hold onto your investments for at least a year before you sell. Long-term capital gains are taxed at lower rates. You'll pay a lesser rate even if you end up owing capital gains tax.

Match losses

One way to reduce taxes is to offset capital gains against capital losses. After selling underperforming investments, the realized loss will benefit your tax bill. However, you must follow a specific order when matching losses to gains:

• Calculate your short-term net profit or loss by subtracting short-term losses from short-term gains.

• Calculate your long-term profit or loss by subtracting long-term losses from long-term gains.

• Add your short-term and long-term gain or loss. You'll pay capital gains taxes if you end up with a gain. When you end with a loss, you can deduct up to $3,000 from your taxable income and carry forward any remaining loss to future years.

Harvest gains

If you’re between jobs or taking time off, your income may be lower than usual. You could find yourself in a lower bracket when your income is less. If you have appreciated assets, this can be a good year to sell because you can pay a lower tax rate on capital gains.

Beyond taxes, the act of minimizing capital gains presents other considerations. You might save money on taxes if you hold assets for more than a year. However, you could miss out on a better opportunity when your funds are tied up. Alternatively, you may have an investment idea that aims to hold your investments for less than a year. If you sell before the year is up, you’ll end up paying a higher tax on profits. Your profit potential needs to factor in that tax bill.

A financial advisor crafts an investment strategy that fits your financial goals while implementing tax-saving strategies such as tax loss harvesting. Meet a financial advisor through FinanceHQ that can tailor a capital gains tax strategy to your needs.