A Guide to Capital Gains Tax

It's great to make a huge profit from selling assets. But first make sure to pay the capital gains tax.

A capital gains tax is a federal income tax levied on capital gains, or profits earned from the sale of a capital assets such as investments, real estate and personal property. The Internal Service Revenue (IRS) and many states calculate capital gains taxes based on the difference between the purchase price (basis) and sale price of an asset.

What Is a Capital Gain?
A capital gain occurs when an individual sells something for more than he spent to acquire it. If an individual buys a used car for about $5,000, for example, and sells it for $7,000 a week later, then his capital gain would be $2,000, the same as if he bought stock for $5,000 and sold it for $7,000. While a lot of people associate the term with bonds and stocks, capital assets are anything an individual owns including houses, coin collections, furniture, jewelries and precious metals.

Cost Basis
An individual needs to determine the cost basis to calculate his capital gains tax from the sale of asset. The cost basis not only includes the price of the item, but also any other costs he had to pay to acquire it such as taxes and fees, delivery costs, commissions as well as installation and setup charges. For some property, such as a house, the cost basis may include the cost of improvement or additions made, such as installing a balcony or putting in a pool. Maintenance costs, however, such as roof repairs and repainting, are not included in the cost basis because they don't improve the house.

What Are the Capital Gains Tax Rates?
The tax rates for capital gains vary depending on whether it's a short-term capital gain (assets held under a year) or a long-term capital gain (assets held more than a year). Tax rates on short-term capital gains are the same as the tax rates on earned income or other forms of ordinary income. Long-term capital gains typically have a lower tax rate compared to its counterpart, capped at about 20 percent in the highest tax bracket. Most taxpayers are eligible for the 15 percent tax rate, and those who belong on the low-income bracket sometimes pay no taxes on capital gains.

For example, if an individual purchased a house for $100,000 and, after five years, decided to sell it for $150,000, his capital gain is $50,000. Because he owned the house for over a year, he calculated his long-term capital gain based on his income tax bracket. Assuming that he is single and has an annual income of about $38,000, he didn't have to pay any taxes on the profit.

Companies that buy and sell assets are not required to pay capital gains tax because they are taxed based on their gross profit, or the difference between the cost of buying the asset and the proceeds from its sale.

There is also a capital gains tax exemption for the sale of a residence, provided that the owner lived in his primary residence for at least two years of the last five years and has not sold the another home within the past two years. As of 2017, individual tax filers may exclude up to $250,000 of their capital gain and married couples may exclude up to $500,000, according to the IRS.