The Big Advantage of Capital Gains Taxes for Investors
As an investor, you are taxed on your profits (which are commonly called realized gains or simply, gains). The good news is that your gains might be taxed at a lower tax rate than you’re used to. This is thanks to capital gains taxes. Capital gains tax rates are one of the many tax benefits of real estate investing, but this benefit can apply to other investment types as well.
Let’s take a look at capital gains taxes: what they are, how they work, and why they are such a big advantage for investors.
What are Capital Gains Taxes?
Capital gains taxes are a special category of income taxes specifically levied on the profit made from selling an investment.
It’s important to understand that you are not taxed on the full sales price of your asset; only on the profit. So, for example, if you purchased stocks five years ago for $10,000 and sold them today for $15,000, you would only be taxed on the $5,000 gain.
Capital Gains Tax vs. Earned Income Tax
Earned income taxes are taxes levied on your normal income (like salaries, hourly wages, or commissions you receive from your job).
If you hold an asset for under a year, the profits are taxed at the short-term capital gains rate, which is equal to the earned income tax rate.
However, if you hold an asset for one year or longer, it is considered a long-term investment for income tax purposes, so it is taxed at the long-term capital gains rate. This rate is significantly lower than the earned income rate in the US.
While income tax brackets can reach as high as 37% (as of 2024) for earned income, the maximum tax rate on long-term capital gains is just 20% (although there is a special 28% capital gains tax on the sale of collectibles).
This differential can result in substantial tax savings for investors.
How are Capital Gains Taxes Calculated?
Calculating capital gains tax depends on how long you hold the asset before selling and which tax bracket you fall into.
Short-Term Capital Gains
As mentioned, short-term capital gains apply to assets held for less than a year. These are taxed as ordinary income.
So, for example, let’s say you earn $12,000 in profit from the sales of a short-term house flip. If you fall into the 24% income tax bracket, your tax on this gain would be $2,880 ($12,000 x 24%).
Long-Term Capital Gains
Long-term gains, for assets held for over a year, benefit from lower capital gains tax rates.
- 0% for profits up to $3,150.
- 15% for amounts between $3,151 and $15,449.
- 20% for amounts over $15,450.
Let’s say you invest $30,000 in a syndicated multi-family build-to-rent project, which takes 24 months to build and is held as a rental for 12 months before being sold. If you earn a 15% annualized return your capital gains on this deal would be $13,500. You would pay 0% on the first $3,150, then 15% of the remaining $10,350, giving you a capital gains tax total of $1,552.50.
That’s a savings of $1,327.50 compared to earned income taxes on the same amount (if you’re in the 24% income tax bracket)!
It is important to note that, while long-term investments benefit from lower capital gains rates, short-term investments often come with higher yields. So don’t ignore strong short-term investments just because of the tax rate.
Which Investments are Taxed as Capital Gains?
Generally speaking, profits from the sale of any appreciating asset can be treated as capital gains. This includes investment types like:
- Stocks and bonds.
- Real estate investments (your primary residence is granted an even higher capital gains exemption than investment properties).
- Mutual Funds, ETFs, and index funds.
Profits from the sale of collectibles are also charged as capital gains, however, these fall into a special 28% capital gains rate.
The Bottom Line
The US government awards investors with lower tax rates on the sale of investments held for a year or longer. Whether you’re selling stocks, bonds, funds, or real estate, you could potentially benefit from this big advantage of capital gains taxes for investors!
Disclaimer: This post is for informational purposes and is not to be considered legal advice. It is always advisable to seek advice from a licensed tax professional before making investment decisions.