Making the Most of Your (Capital) Gains: Maximizing Your Take-Home Profit with the Capital Gains Tax

What are capital gains?

A capital gain occurs when an investor profits from the sale of an asset such as stock, real estate, or other investment. Investors pay a special tax rate on capital gains, that may be less than the ordinary income tax rate. Capital gains are taxed uniquely by the IRS.

This special capital gains tax rate varies depending upon how long the investor has held the asset. At the federal level, investors may be subject to either short-term or long-term capital gains taxes, which have different rates. Additionally, investors may have to deal with state capital gains tax in many states, including Colorado.

Capital gains are most often reported to the IRS on a Form 1040, Schedule D, but investors may also have to report capital gains from the sale of a property that had a business use on a Form 4797, which will flow back to the Form 1040.

a.     Short-term Capital Gains Tax

            The short-term capital gains tax applies to profits from the sale of assets that were held for less than one year. Short-term capital gains are taxed at the same rate as the taxpayer’s ordinary income (10%, 12%, 22%, 24%, 32%, 35%, or 37%).

b.     Long-term Capital Gains Tax

            Long-term capital gains are usually the most tax-efficient option for investors because the long-term capital gains tax rate can be significantly lower than the corresponding income tax rate, especially for wealthier investors. The long-term capital gains tax applies to capital assets held longer than one year. The long-term capital gains tax rate is currently zero, fifteen, or twenty percent depending upon the filer’s status, taxable income, and tax bracket.

c.      State Capital Gains Tax

            Most states in the nation impose their own capital gains tax on top of the federal rate, including Colorado. Colorado currently assesses an additional 4.63% tax rate on capital gains through a state tax on investment income.

Selling an Investment Property?

Depreciation Recapture Tax. The IRS imposes a depreciation recapture tax on assets that the filer sells for a profit and has previously used to offset or deduct taxable income. Depreciation allows a landlord to expense a portion of the cost of an investment property. This allows the owner to allocate the costs of the asset over the useable lifetime of the asset. The depreciation recapture tax means that the owner may receive a deduction to their taxable income today, but they will likely have to pay depreciation recapture in the amount previously expensed when they sell the property.

Net Investment Income Tax. The NIIT is an additional 3.8% tax on investment income triggered when the filer’s overall income exceeds $200,000 for single filers or $250,000 for joint filers. Investment income is defined by the IRS as including, but not limited to: “interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer.”

Capital Losses. Capital losses offset the amount of taxable capital gains incurred in a year. Capital losses occur when an investor sells an asset for less than what they purchased it for, thus incurring a loss. To determine a filer’s taxable net capital gains for the year, take the capital gains incurred less the capital losses incurred in that year. For example, if an investor sells two properties in a year, one for a profit of $100,000 and one for a loss of $25,000, the investor’s taxable net capital gain for the year is $75,000.

1031 Exchanges of Like Kind. Exchanges of like kind may be used by real estate investors to defer their tax liability if they dispose of their real estate and acquire another investment property of a “like kind.” Like-kind exchanges allow investor’s interest to accumulate, tax-free, over time. Again, this is a way of postponing (not eliminating) taxes from the sale of a rental property. Like kind exchanges can only involve investment properties, so homeowners cannot exchange primary residences when they move states. To make what is called a “delayed” like kind exchange–the most popular type of exchange–the seller of the property must find another replacement property within 45 days of selling the first property, and they must buy that replacement property within 180 days of selling the first.

Shopping Your Private Residence?

The home sale exclusion refers to a Section 121 Exclusion in the Internal Revenue Code. The exclusion allows single filers to exclude up to $250,000 and allows joint filers to exclude up to $500,000 in capital gains when they sell their primary residence. A primary residence means the owner has occupied the residence for two out of the last five years, which allows for some flexibility and creativity for investors. For example, a residence may qualify as primary even if the owner has rented the property out for three out of the five years, so long as they occupied it for two of the previous five. 

Additionally, any capital gains excluded by the Section 121 home sale exclusion are also excluded when calculating Net Investment Income. Accordingly, when selling a private residence, the first $250,000 or $500,000 of capital gains are tax-free for purposes of determining both regular income tax and Net Investment Income Tax.

Unfortunately for savvy investors, the home sale exemption may only be used once every two years, so investors cannot alternate primary residences each year while renting the other in hopes of benefitting from two home sale exemptions at the same time. An additional limitation on the home sale exclusion is that it cannot be applied to the sale of a property that was acquired through a 1031 like kind exchange within the last 5 years.

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GLO has prepared this blog to provide general information on legal issues that may be of interest. This blog does not provide legal advice for any specific situation and this does not create an attorney-client relationship between any reader and GLO or its attorneys. GLO engages clients only through specific fee arrangements and signed engagement letters. GLO does not guarantee any results.