What Are Capital Gains?
Capital gains are the profits made when you sell an appreciated asset. Before you sell the asset, the increased value is called an unrealized capital gain. For example, if you bought Bitcoin for $100,000 and five years later it is worth $500,000, your unrealized gain would be $400,000. As long as you are holding the asset, you haven’t made any profit. You do not owe taxes on the appreciated value, yet.
As an investor, you can hold onto assets indefinitely and won’t ever owe taxes until you sell the asset and realize the gains. Once you sell an appreciated asset, and take possession of the profits, your gain is subject to federal and state taxes. The amount your gains will be taxed is dependent on how long you’ve held your asset, your income level, and the state you live in. So, if you sell your crypto for $800,000 three years down the road, you will realize a capital gain of $700,000 and owe taxes on that amount.
Short-Term vs. Long-Term Capital Gains
Short-term capital gains are the profits made on an asset an investor has held for less than a year. For example, if you bought an investment property for $200,000, renovated it, and then sold it for $800,000, all in less than 12 months, the $600,000 would be considered a short-term capital gain.
The federal government taxes short-term capital gains as ordinary income. In this scenario, you would include the $600,000 as part of your income when you file your taxes, which would be taxed at income tax rates. The highest federal income tax bracket in 2024 is 37%. Therefore, you would owe around $222,000 of your gains in taxes.
Long-term capital gains are profits made on assets held for more than a year, and they are given preferential tax treatment. For example, if you purchased a commercial property for $500,000, rented it out for ten years, and then sold it for $1.5 million, your capital gains would be $1 million. The long-term capital gains tax rate would apply to your gains because you held the asset for over a year.
Your income tax bracket determines your capital gains tax rate. For long-term capital gains this may be 0%, 15%, and 20%. At the highest tax bracket, you would owe $200,000 in federal capital gains taxes in this scenario. Each state can also levy an additional short-term or long-term capital gain tax, and the rate varies from state to state.
What is Investment Income?
Investment income is an umbrella term that applies to capital gains and any other form of income from investments. Investments cover a wide range of financial instruments. Other forms of investment income include dividends, rental income, royalties, and interest income.
Dividends
If you invest in shares of a company’s stock, sometimes the company will share portions of its profit with investors. This is called a dividend, like a thank you from the company for owning stock.
For example, a company might distribute .25 per quarter per share. If you own 50 shares of stock in that company, you would receive $12.50 per quarter or $50 annually.
Rental Income
In the capital gains example above, you owned a commercial property that you rented out for ten years. The profit you made by selling the property at the end of the ten years was capital gains, but all of the rental income you received over the course of the ten years is a form of investment income.
Royalties
You might receive royalty payments if you invest in creative works or intellectual property, such as books and music. Royalties are payments made to an owner for using an asset, such as streaming a song, buying a book, or using brand property.
Interest Payments
With certain types of investments, you are loaning money to a private or government entity. A bond is issued by the government or a business to raise money. You are giving them a loan, and they agree to pay you back by a specific date and issue you interest payments along the way.
Certificates of deposit (CDs) and savings accounts work much the same way. You don’t have ownership in the company or the government, so your investment won’t appreciate if the organization does well, but you will receive a steady stream of interest income.
If you put $500,000 into a CD with a 6% interest rate, you would earn $30,000 in investment income in your first year.
Taxes on Investment Income vs. Capital Gains
Aside from the profits from capital gains, investment income is taxed like ordinary income.
Let’s say that Carlos makes a salary of $450,000 a year. He owns two rental properties that bring him an additional $100,000 a year in rent. His stocks have done well this year, growing from $200,000 to $250,000. He also has money in bonds that pay 6% in interest, and he earned $10,000 this year in interest. At the end of the year, he decides to sell one of his rental properties for a profit of $500,000. Since his stocks are doing well, he decides to hang onto them and not sell them now.
Carlos would calculate his net income by adding the $100,000 he made in rental income and the $10,000 he earned in interest to his salary of $450,000. He would be taxed on $560,000 of income. He doesn’t sell his stocks, so that is an unrealized gain that isn’t taxed. He would pay capital gains taxes on the $500,000 profit from selling his rental property. At a 20% federal rate, he would owe the government $100,000 in capital gains taxes. When you add the state capital tax rate, which can range from 0% to 13.3% depending on the state where the asset is held, Carlos’ total capital gains tax liability could reach $166,650.
Capital Gains Tax Options
One way for Carlos to mitigate and reduce his capital gains taxes is to be in control of the timing. If he were to sell his rental property in a year when his overall income was less than $500,000, he would only owe 15% in taxes rather than 20% for the long-term capital gains taxes.
However, timing is tricky with real estate, and if he waited to sell, the market might drop, and he could lose out on potential profits. One way to maximize the timing of your asset sale and control the timing of your tax liability is to use an investment solution such as a Deferred Sales Trust. A Deferred Sales Trust allows you to sell when the market is favorable but delays your exposure to capital gains taxes until the timing is beneficial. I can also help you spread your tax payments out over time.
If you want to know how to reduce your capital gains tax, or you think a Deferred Sales Trust could be a key component of your wealth tax plan, contact a qualified tax professional who can help you make an informed decision and maximize your investment returns.