The U.S. uses a progressive tax system, meaning that the more money you make, the more you’ll owe in taxes. However, all income isn’t created equal, and the type of gains you receive will determine how it’s taxed.
How capital gains work
As a way to encourage people to invest, long-term capital gains — the profit earned from selling an asset you’ve held longer than one year — are taxed more favorably than your regular income. With income taxes, you fall into one of seven brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. On the other hand, capital gains have a simpler structure, with the following percentages based on your income level:
Income Range (Single Filer)
Capital Gains Tax Rate
$0 to $40,400
$40,401 to $445,850
$445,851 or more
Income Range (Married Filing Jointly)
Capital Gains Tax Rate
$0 to $80,800
$80,801 to $501,600
$501,601 or more
If you were to buy 1,000 shares of a company at $30 each and then sell those same shares for $50 later, you’d owe capital gains tax on the $20,000 in profit you made. If you’re single and make $100,000, you’d owe 15% of that $20,000 gain, or $3,000, in capital gains taxes.
As we enter tax season, here are three unusual capital gain rules you should watch out for.
1. Small business stock
The IRS defines a small business as any active C corporation with $50 million or less in assets at the time of its stock offering, and thanks to Section 1202 of the Internal Revenue Code (IRC), different capital gain rules apply. If you sell shares of a qualified small business stock (QSBS), the greater of $10 million or 10 times your adjusted basis — which is essentially the cost you paid for them — is free from capital gains taxes if you’ve held it for at least five years.
If you bought 100,000 shares of a company at its initial issuance for $20 each ($2 million total) and later sold all the shares, $20 million would be exempt. Had you bought those same 100,000 shares for $5 ($500,000) and later sold them, $10 million would be exempt.
One downside, however, is that any excess amount earned over the exemption is subject to a 28% capital gains tax. Also, these rules don’t apply to businesses in financial services (banking, insurance, and investing), farming, restaurants, and hotels.
2. Assets labeled as collectibles
Collectibles — such as rare items, art, coins and stamps, cards, and antiques — are considered alternative assets by the IRS. While other investments are taxed at your income’s standard capital gains rate, long-term gains on collectibles are taxed at a maximum rate of 28%.
Let’s say you bought a piece of art for $10,000 and later sold it for $100,000. Assume that you’re in the highest ordinary income tax bracket. Under normal circumstances, you’d pay 20% (your maximum long-term capital gains tax percentage) on the $90,000 in profit, creating a $18,000 tax bill. But since art is considered a collectible, you’d pay the higher maximum 28% rate, making your tax bill $25,200 — an $7,200 difference.
3. Property under Section 1250
When assets lose value over time, it’s considered depreciation. Section 1250 of the IRC deals with taxing gains made from selling depreciated real estate property, including rental properties, commercial buildings, and warehouses.
Let’s assume someone purchases a rental property for $500,000 with a 30-year useful life and five years down the road claims accumulated depreciation of $100,000, making the property’s tax basis $400,000. If they sell the property for $450,000, the taxable gain will be $50,000.
Unlike regular long-term capital gains, which are capped at 20%, the gain here is taxed at 25% ($50,000 * 25%), creating an additional $2,500 tax bill.
Be mindful of what you’re going to pay in taxes
More than anything, it’s important to know how much taxes you owe, not just on your regular income, but on the money you make from investments. A surprise tax bill can not only be costly, but it can disrupt your financial plans. Planning accordingly can work wonders.
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