(Forbes) We have been in an amazing bull market for more than ten years. In 2019, we saw the U.S. stock markets continue to climb to record highs. While this is amazing news for your net worth, it may come with some substantial tax bills when you eventually sell your investments. How much you end up owing in taxes on your investments will mostly depend on two factors: 1) How much the value of your investments has increased and 2) How long you have held your investments.
When you sell an investment (stocks, bonds, mutual funds, ETFs, real estate) for more than your cost basis, your net profit will be taxed as a capital gain.
Capital gains can be either long term or short term. Which type you incur will depend on how long you have held your investments. The period of time to keep in mind is one year. If you owned the investment (or even just certain shares of the investment) for one year or less, you would incur short-term capital gains. For assets held longer than one year and one day, the profit will be taxed as long-term capital gains.
Long Term Capital Gain Brackets for 2020
Let’s take a look at how long-term gains are actually taxed. In many cases, long-term capital gains will have favorable tax treatments. That means you will likely pay less taxes on long-term capital gains than you would other types of earned income, like your salary. Long-term capital gains are taxed at the rate of 0%, 15% or 20% depending on your taxable income and marital status.
For single folks, you can benefit from the zero percent capital gains rate if you have an income below $40,000 in 2020. Most single people will fall into the 15% capital gains rate, which applies to incomes between $40,001 and $441,500. Single filers, with incomes more than $441,500, will get hit with a 20% long-term capital gains rate.
The brackets are a little bigger for married couples, filing jointly, but most will get hit with the marriage tax penalty here. Married couples with incomes of $80,000, or less, remain in the 0% tax bracket, which is great news. However, married couples who earn between $80,001 and $496,600 will have a capital gains rate of 15%. For those with incomes above $496,600 will find themselves getting hit with a 20% long-term capital gains rate.
Additional Medicare Taxes for Higher Earners
There may be additional taxes or lost tax deductions for people with higher incomes. For example, taxpayers with incomes of more than $250,000 will also be required to pay an additional 3.8% net-investment surtax. This Medicare surtax is applied to all investment income regardless of whether the capital gains are long term or short term.
Short-Term Capital Gains
Short-term capital gains are typically taxed as ordinary income. If you hold an investment for less than one year, any gains, or losses, will be treated as short-term capital gains or short-term losses. The good news is that up to $3,000 of short-term losses can be deducted against regular income each year. That provides a great opportunity to lower your taxes with tax-loss harvesting.
Related: How Your Company Stock Options Will Be Taxed
Tax-Loss Harvesting
The stock market hasn’t been kind to everyone. I just took on a new client whose previous advisor appeared to have the golden touch for picking bad investments. Every single mutual fund that this client held with their previous advisor was down since they purchased them. The fact that they were all proprietary and commissioned with high fees probably didn’t help. The good news is that this gave us some opportunities to do some proactive tax planning and take advantage of the generous tax-harvesting laws.
Taxes on Investments in Retirement Accounts
Gains in your 401(k), Traditional IRA, Defined Benefit Pension Plan, 403(b) and Tax Sheltered Annuities (TSA) will be tax-deferred. You most likely won’t owe any taxes on your retirement accounts until you make a withdrawal. If you have a Roth 401(k) or Roth IRA, your withdrawal will be tax-free assuming you follow Internal Revenue Service (IRS) rules.
Real Estate Taxation
The capital gains rules are different when you own real estate. There are two main tax rules you need to know about when discussing taxes on the sale of real estate.
When you sell your primary residence, you may be able to avoid paying a substantial amount of taxes on your gains. Homeowners who are single (not married) may be able to exclude up to $250,000 in capital gains on the sale of their primary residence. This number doubles to $500,000 for a married couple selling their primary residence. There are a few rules you need to follow to get this large tax break, most notably, you must have lived in your primary residence at least two of the past five years.
According to Zillow, the median home price in the United States is $243,225. With that in mind, a vast majority of home sales will have no taxes owed. Now, I’m a financial planner in Los Angeles, where $243,000 is barely a down-payment in many parts of Southern California. Many homeowners in high-cost areas, like SoCal, will end up owing taxes on the sales of a primary residence, even after the $250,000 / $500,000 exclusion.
Keep in mind that the taxable gain is based on the cost basis of your home, not just the purchase price. So, keep track of all those home improvements or remodeling projects that you spent money on, which can increase the cost basis of your home. The higher your cost basis, the smaller your tax bill will be once you finally sell your home. For example, if you purchase a McMansion in Beverly Hills for $4 million, then spend $1 million remodeling it, you would have a cost basis of $5 million. If you are married and lived there for two of the past five years, you could sell it for $5.5 million without having to pay any capital gains taxes on the sale.
The rules are slightly different for investment properties. You will owe capital gains taxes on the net profit from the sale, but you will also owe gains on the cumulative depreciation benefits you have received while you owned the property. That process is known as depreciation recapture. It is a topic too complicated to discuss here, completely. I just needed you to be aware that on investment properties, your cost basis is likely less than you put into the property. Talk with your Certified Financial Planner and CPA before selling your investment property to make sure you understand the tax consequences. If you are selling one property to buy another, you may be able to defer taxation with a 1031 exchange.
Investment Long-Term Capital Gains Example
Here is a quick example of how all of these long-term capital gains stuff works. Let’s say you and your spouse have a taxable income of $500,000 (excluding your investment income) and purchased shares in a company in January 2017. Let’s use Apple as an example, for $100,000. Then you sold this stock for $150,000 in January 2020. That is a gain of $50,000. You held the stock for more than a year, so it will be treated as long-term capital gains. With an income of $500,000, you will owe 20% on your capital gains, so this sale of stock will add $10,000 to your overall federal tax bill. You will also get hit with a 3.8% Medicare Surtax on some or all of your gains.
Should You Avoid Short-Term Capital Gains?
Taxes should only be part of the equation when making decisions on whether to hold or sell investments. That being said, you should be aware of how long you have held the investment and try to avoid short-term capital gains. The IRS tax code encourages long-term investing or holding an investment for at least year. In most cases, long term capital gains rates will be lower than your earned income tax rates.
As a fiduciary financial planner, I typically use diversified portfolios for my clients. We try to avoid tons of buying and selling that will incur unnecessary taxes. For the typical investor or retirement saver, there is little to no reason to be constantly buying and selling, beyond investing new contributions to your account.
Make your buying automatic, put money away each and every month into a well-diversified portfolio. Use low-cost index funds and go on enjoying your life. There is no benefit to checking your investment account 50 times a day. All you will be doing is increasing your chances of making a big investment mistake, or at the very least, stressing yourself out.
