How Taxes Work: Capital Gains

Written By Roshan Pourghasemi

In this article we will cover:

• How capital gains are calculated

• How short-term capital gains are taxed versus long-term capital gains

• Using capital losses to offset income

  • Wash sale

  • First In First Out

  • Last In Last Out

How are Capital Gains Calculated?

The capital gains tax is calculated when your investment is “realized”. For tax purposes, your capital gain is generally realized when you sell your asset. To that end, your assets can continue to appreciate and you won’t have to pay any taxes until you actually sell the asset. Many investors will take loans out against their assets, since this would help them avoid the taxes by not actually selling the assets.

The amount that your asset is taxed is based on the profit that you made on this asset. This is calculated by subtracting the amount you made on the sale from your “basis”. Your basis is the amount you paid to own the asset, but it can include many of the costs associated with the sale. For example, expenses that are part of the sale process, like closing costs or realtor fees, can also be included in your basis. Since the amount of money that you are taxed on is the sale price subtracted by the basis, you want to maximize to pay the least possible amount in taxes.

Short-Term vs. Long-Term Capital Gains

There are two types of capital gains taxes: short-term and long-term. You incur short-term capital gains when you sell your asset within a year of the official purchase date. Short-term capital gains are taxed at a higher rate than long-term capital gains and follow the same tax breakdown as federal income tax. The following is a table of the tax rates for capital gains.

Do My Capital Losses Help At All?

Luckily, if you’ve lost some value in your assets over the year, there could be some tax benefits involved. First, it is worth noting that your capital gains tax is calculated on your net gains from all investments. So, if your gains outweigh your losses, then you are subject to capital gains tax. If your losses outweigh your gains, however, you can use that to reduce your taxable income. You can use up to $3,000 in losses per year to subtract from your taxable income. Any further losses can be carried into subsequent years to offset your taxable income up to $3,000.

The Wash Sale Rule

A wash sale is when someone sells an individual security at a loss and they buy the same or identical security within 30 days before or after this sale. A wash sale also occurs if an individual sells a security and their spouse or company buys it back within the previous period. If you participate in a wash sale, you cannot use the losses that you incurred in your sale for tax benefits. The IRS views this activity as creating an artificial loss for tax breaks, and won't allow investors to use it to exploit the capital gains rules.

How to Sell Securities

There are multiple strategies to consider when you want to sell your securities.

• The average cost basis method is a way for investors to calculate their gains and losses, especially when it comes to mutual funds. The investor takes the amount they’ve invested and divides it by the amount of shares they own. This amount is then subtracted from the amount that each security cost at the time of purchase. You multiply this by the amount of shares sold to calculate your gain or loss.

• The first in first out (FIFO) method dictates that you must sell the first ones you purchased when selling your securities. Say you bought 40 shares of a security in April and then 50 in July and you wanted to sell 60 shares. To calculate your capital gains, you would first add up the cost of the 40 shares you bought in April and then the remaining 20 shares would be added at the cost that you bought in July. You then subtract the amount you sold for to figure out your capital gains. FIFO results in lower taxes paid if you’ve held a security for longer than a year due to lower long-term capital gains rates.

• The last in first out (LIFO) is the opposite of the previous method, where an investor sells the most recent shares purchased first. This works best if an investor wants to hold onto the initial shares that were purchased, which could be at a lower price relative to the current market price.

The specific identification (SpecID) method allows the investor to specifically pick which shares sold they want to contribute to their taxes. Say you bought 10 shares in January and 20 in February. If you sold 15 shares, you could take any combination of shares from each. For example you could choose to calculate your taxes from selling 8 shares in January and 7 in February.

Key Takeaways

• Capital gains is the tax that you pay on your investments.

• Capital gains is calculated when your investments are realized, generally meaning when you sell your investment.

• You are taxed on the total gain subtracted by the total amount of losses you had over the tax year.

• The amount you bought the asset for plus the associated costs minus the amount you made on its sale is the amount you are taxed on.

• Capital gains comes in both a short-term and long-term form, where long-term (held for longer than a year) carries lower tax rates.

• You can deduct up to $3,000 of your losses from your taxable income.