For US investors, understanding Capital Gains Tax (CGT) is crucial for managing investment returns. This article will delve into the specifics of US CGT, explaining how it’s calculated, what your reporting obligations are, and how to invest as tax-efficiently as possible.
Capital Gains Tax (CGT) applies to the profits realized from selling assets like stocks or bonds. It is crucial that investors understand which of their assets fall within the scope of CGT, how it works, and how to be compliant. There may also be opportunities to reduce the tax burden.
What is capital gains tax?
Capital Gains Tax is a levy on the profit made from selling capital assets which can include shares, crypto, bonds, or other types of investments. If you purchase shares for $1,000 and later sell them for $1,500, the capital gain is $500.
It’s important to note that CGT is only applicable when a gain is realized, when an asset has been sold. If you hold an asset which has increased in value but has not been sold yet, you have an unrealized gain and no CGT to pay, unless you sell it.
Short-term vs. long-term capital gains
US Capital Gains Tax rates differ based on how long you’ve held the asset. This distinction can significantly impact your tax liability.
Holding periods explained
Assets held for one year or less are considered short-term, while those held for more than one year are classified as long-term. This holding period is crucial as it determines the tax rate applied to your gains.
Different tax treatment
Short-term and long-term capital gains are taxed differently. Short-term gains are taxed at ordinary income tax rates, which can be higher than the rates for long-term gains. This leads us to the next section on current tax rates.
Current US capital gains tax rates
US Capital Gains Tax rates are subject to change but are publicly available. Keeping up to date is crucial and while there are many online sources that are available, the “golden source” of information is the Internal Revenue Service (IRS) website.
What are long-term capital gains tax rates?
Long-term capital gains are taxed at lower rates than short-term gains, with rates of 0%, 15%, or 20% depending on your taxable income.
Tip: Consider consulting a qualified tax professional to fine-tune your approach to CGT.
What are short-term capital gains tax rates?
Short-term capital gains are taxed at your ordinary income tax rate. These rates can fluctuate, so it’s wise to consult current tax brackets or a reliable resource.
The net investment income tax (NIIT)
The NIIT is a 3.8% surtax on certain net investment income for individuals, estates, and trusts with income above specific thresholds. This additional tax can impact high-income investors.
State capital gains taxes
Some states also impose their own capital gains taxes, which vary by state. It’s advisable to check your local state laws to understand your full tax obligations.
Capital gains tax exemptions
Certain assets have specific CGT rules. For instance, gains from the sale of a primary residence may be partially or fully excluded from income if specific ownership and residency conditions are met. Investment real estate can involve considerations like 1031 exchanges, which allow for the deferral of capital gains tax. Long-term gains on collectibles, however, are taxed at a distinct maximum rate of 28%.
How to calculate US capital gains tax
Calculating CGT starts by determining your cost basis and subtracting it from your sale proceeds. You then follow a set of standard protocols to establish how much CGT you owe.
Tip: Keeping accurate records is crucial for correct gain/loss calculation.
Determine your cost basis
The cost basis is the original value of an asset for tax purposes, usually the purchase price plus any associated costs like commissions. This figure is crucial for calculating your gain or loss and needs to be adjusted for events like stock splits, reinvested dividends, and return of capital distributions.
Calculate net capital gains
To find your net capital gains, subtract your cost basis from the sale proceeds. You can net short-term gains/losses against each other and do the same for long-term gains/losses.
Consider capital loss deductions and carryovers
Net capital losses can offset other income, up to a certain limit, such as $3,000 per year. Excess losses can be carried forward to future years, a strategy known as “Tax Loss Harvesting.“
Other CGT considerations
High-income individuals should also factor in Net Investment Income Tax (NIIT), which may apply to their capital gains and other investment income. Furthermore, specific exclusions can apply, such as the home sale exclusion, which allows eligible taxpayers to exclude a significant amount of capital gain from the sale of their primary residence from their taxable income, provided certain conditions are met.
Reporting capital gains to the IRS
US Capital Gains Tax is governed by IRS rules and regulations. The onus is on individual investors to ensure that their CGT reporting and payments are accurate and on time.
Tip: Check if your broker provides detailed, tailor-made tax reports to help you file your tax returns
Key IRS forms
Several forms are crucial for reporting capital gains, including Form 1099-B, Form 8949 (Sales and Other Dispositions of Capital Assets), and Schedule D (Form 1040, Capital Gains and Losses).
Record keeping and deadlines
Maintaining accurate records of all investment transactions is vital. These records support your tax filings and ensure compliance. Tax filing deadlines are typically in April each year. It’s important to adhere to these deadlines to avoid penalties.
CGT and cryptoassets
Digital assets are treated as property for U.S. federal tax purposes and are subject to capital gains tax if they are capital assets. This has been the IRS position for several years. New reporting requirements for brokers handling digital assets are expected to apply to transactions from 2025 onwards, to be reported using Form 1099-DA starting in 2026.
Tip: Form 1099-DA will be similar to Form 1099-B for digital assets
Strategies for tax-efficient investing in the US
While you can’t avoid paying CGT which is owed, there are strategies you can use to set your portfolio up to be more tax-efficient. These include:
- Hold investments for the long term – a buy-and-hold strategy can qualify you for lower long-term CGT rates, potentially reducing your tax liability.
- Tax-loss harvesting – selling investments at a loss to offset gains can reduce your net taxable income.
- Utilize tax-advantaged accounts – Accounts like 401(k)s and IRAs offer tax-deferred or tax-free growth, although withdrawals may be taxed.
- Gift assets – Gifting appreciated assets can have different tax implications, which may be advantageous for some investors.
- Allocating capital wisely – Dividends received on a stock that would generate a capital gain if sold can be invested in underperforming assets instead of the stock that generated the income. This can help with overall rebalancing of your portfolio.
Final thoughts
Navigating US Capital Gains Tax can seem complex, but understanding its core principles is vital for any active investor. By familiarizing yourself with how CGT is calculated, reported, and the strategies available for tax efficiency, you can make more informed investment decisions.
Remember that tax laws can change, as can your individual circumstances, so consider consulting with a qualified tax professional for personalized advice. The knowledge you gain will empower you to manage your portfolio with greater confidence and potentially improve your after-tax returns.
Learn more about tax-efficient ways to invest by joining the eToro Academy.
FAQ
- Do I need to report small capital gains from my investments to the IRS?
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Yes. All capital gains should be reported to the IRS according to the rules and regulations, regardless of size.
- Do I have to pay capital gains taxes immediately?
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Not necessarily. CGT is typically paid when you file your annual tax return, so there may be a time difference between when you close your trade out and need to make payment to the IRS. This timeline applies to all assets which fall within the scope of CGT.
- What is the “wash sale” rule?
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The “wash sale” rule is a regulation set up by the IRS to limit the capacity for investors to avoid paying CGT by booking short-term trades. When engaging in tax-loss harvesting you must avoid selling a security at a loss and buying the same or a “substantially identical” security within 30 days before or after the sale. Breaching that rule will disallow any loss deduction for tax purposes in that year.
- Who is responsible for submitting form 1099-B?
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The responsibility for ensuring a form 1099-B is filed in an accurate and timely manner ultimately rests with the individual investor. Saying that, some brokers offer support services which can aid the process. eToro, for example, reports the account proceeds (generally with costs factored in) of US clients to the IRS and the account holder via the APEX reporting system. The account holder still has to report the gains, but some of the processing work is done by the broker.
Trading may have tax consequences. eToro does not offer tax advice. Please consult with a tax professional.
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