How are capital gains taxed?

A capital gains tax is essentially a tax on a profit made from the sale of a capital asset, and is assessed depending on the nature of the asset sold. For example, if you sell a rental house at a substantial profit, the proceeds would be subject to a capital gains tax. Capital gains taxes do not cover the general sale of inventory, so if you operate a small business out of your home the proceeds on the sale of your product would not be subject to a capital gains tax.

Long-Term and Short-Term Capital Gains Taxes

Once you determine that the item you sold is an asset subject to a capital gains tax, the actual implementation of that tax depends on the nature of your gain from the sale. The IRS has two main categories of capital gains: short-term and long-term.

"Short-term capital gains" are assets that have been held and sold for a period of less than one year. Historically and currently, they receive less favorable tax treatment than long-term capital gains. In 1997, gains from capital assets held 12 but less than 18 months were originally taxed at a maximum rate of 28%. In 1998, Congress lowered the holding period for the 20% rate to just 12 months. Despite this change in 1998, short-term capital gains are still taxed at the same rate as ordinary income.

"Long-term capital gains" are taxed at more favorable rates. The special treatment for long-term capital gains was designed to encourage people to make greater investments in their communities. In 1997, gains from capital assets held at least 18 months were taxed at a maximum rate of 20%. After 1998, the maximum rate continued set at 20%. In 2003, Congress reduced the 20% tax break for long-term capital gains down to 15% through 2008. Congress eventually approved lower capital gain taxes for individuals in certain tax brackets. For taxpayers in the 10 and 15% tax brackets, the rate on capital gains was reduced to 5% in 2003 through 2007, and to zero through 2012.

In 2013, the tax rate for long-term capital gains kicks back to 20%, but only for high income taxpayers (single individuals earning more than $400,000 and married couples filing jointly earning more than $450,000). Taxpayers in the 10 and 15% tax brackets pay capital gains tax on securities held for more than a year; those taxpayers that fall in the 25%--35% tax bracket are taxed at 15% on any long-term capital gains.  Moreover, beginning in 2013, higher-income taxpayers are also subject to a 3.8% Medicare tax created by the new health-care law (Patient Protection and Affordable Care Act) on short-and long-term capital gains over specified thresholds.  

Getting Help with Capital Gains Tax Issues

How your capital gain is classified will have the most influence on how you are taxed for capital gains. If you anticipate a large capital gain, you may want to consult with an attorney who specializes in tax law to review options for reducing your capital gain tax. If the sale is related to a gift you eventually plan to leave to an heir or a charity, you may also want to consult with an estate planning attorney to review strategies for disposing or allocating gifts that reduce your tax liability. The most important thing to remember is to ask for help if you don’t fully understand the law, since failure to pay capital gain taxes, as with any other tax obligation, can potentially result in audits, interest penalties, and charges of tax evasion. An attorney that specializes in tax law is worth the investment to avoid future issues with the IRS.