How To Avoid Capital Gains Tax

Nothing beats making a good investment. It can feel like you’ve made a ton of money for literally doing nothing. But wait, what’s this, Uncle Same wants their piece of your profits? You did all the work; why should the government get any of it?

When you sell one of your investments for a profit, you’ll owe what is known as capital gains tax. Can we learn how to avoid capital gains tax? Unfortunately, there is no way to avoid altogether paying these taxes, that’s called tax fraud and is a big no-no, but there are ways to reduce the amount you’ll owe.

What Is a Capital Gains Tax?

As stated above, when selling your investments for a gain, you’ll owe taxes on those gains. These taxes are what is known as capital gains tax. Think of it the same way you get taxed on your ordinary income, only you didn’t have to work nearly as hard to earn the money you’re getting taxed on.

Gains are taxed once they become realized capital gains instead of unrealized capital gains. When investors talk about unrealized gains, they talk about their investments have risen in value, but they have not sold yet. Unrealized gains exist only on paper. Once you sell an investment is when your gains can be considered realized gains, and at that point, you’ll be taxed on them.

Which Assets Qualify for Capital Gains Tax?

Capital gains taxes apply to what are known as capital assets. Before you can learn how to avoid capital gains tax, you should know what assets they apply to. Examples of capital assets include, but are not limited to:

  • Stocks
  • Bonds
  • Jewelry
  • Your home
  • Household furnishings
  • Your vehicle
  • Gold and silver
  • Novelty Collections (coins\stamps etc.)

However, not every capital asset you sell will be subject to capital gains tax. Examples of noncapital assets include:

  • Business inventory  
  • Accounts receivable acquired in the ordinary course of business
  • Depreciable business property
  • Real Estate used in your trade or business as a rental property

Also excluded from capital gains treatment are certain self-created intangibles, such as:

  • Copyrights
  • Literary, musical, or artistic compositions
  • Letters, memoranda, or similar property
  • A patent, invention, model, design (patented or not), or secret formula

Short-term vs. Long-term Capital Gains

Similar to tax brackets on ordinary income, there are different amounts you could get taxed on your capital gains. It typically depends on how long you held the investment when determining the tax amount.

Short-term capital gains are gains on investments you’ve held for less than a year. The tax brackets on short-term capital gains are similar to those for ordinary income. However, short-term capital gains tax also considers your filing status (single, married, etc.) As a result, the tax rate on short-term gains maxes out at 37%.

Long-term capital gains taxes are paid on investments you’ve held for a year or longer. The brackets for long-term capital gains are a bit easier. In 2022, if you made less than 41k for a single filer or 83k for a married couple, you’ll pay nothing in capital gains taxes. Those numbers then jump to 445k for a single filer and 501k for a married couple. If your income is below those thresholds, you’ll be in the 15% tax bracket on your capital gains. Above that, the cap on long term capitals gains is 20% 

Will I Owe Capital Gains Tax if I Sell My Home?

Selling your house is a special case for capital gains tax. Selling your home is a special exclusion to paying these taxes, no matter your income. If you have less than $250,000 in capital gains when selling your home, you’ll pay nothing in taxes. The amount is bumped up to $500,000 for a married couple. 

The special exclusion does not apply to investment properties. You will only avoid paying capital gains tax if you sell your primary residence and you have lived there for two of the previous five years.

If your gains exceed the thresholds, you will only pay capital gains tax on the excess amount. So, for example, if you had capital gains of $300,000 from selling your home as a single filer, you’d only pay taxes on the excess $50,000.

How To Avoid Capital Gains Tax or Minimize It

Below are a few tips and strategies you can use to reduce or avoid paying capital gains taxes you owe.

Invest for the Long Term

As mentioned earlier, once you hold an investment for over a year, it’s considered a long-term investment. Long-term capital gains are typically taxed lower than short-term capital gains. Be aware of your investment dates, and make sure you cross that one-year threshold before selling anything you don’t have to. By doing this, you can significantly reduce any capital gains taxes you’ll need to pay.

Use Tax-deferred Retirement Plans

Taking advantage of Tax-deferred retirement plans is another way to reduce your capital gains taxes. Retirement accounts such as 401ks, IRA, or 503bs are good examples. Even if you sell investments for a gain within these accounts, you are not taxed on the capital gains. Not until you withdraw the money will you need to pay taxes. 

The idea here is that when the time does come that you need to withdraw money from your retirement accounts, you’ll be, well…retired. Typically, your income drops once you retire, and you’ll be in a lower tax bracket. Therefore when you withdraw the money, you’ll owe less in capital gains taxes.

Gift Your Stock

Did you know that you can gift stock to a family member? It’s true. You can give up to $15,000 worth of stock to a family member. The strategy here would be to give it a relative in a lower tax bracket than you. In this case, you can significantly reduce the amount of capital gains tax or even avoid paying capital gains tax altogether. 

You can also gift appreciated stock to charities to avoid paying capital gains tax. You’ll also get the income tax reduction for the stock’s fair market value.

The laws surrounding both of these scenarios can change every few years, so always make sure you are up to date on the latest before attempting either of these strategies. 

Include Capital Losses in Taxes

We all like to talk about our investing wins, but don’t forget about your losses, especially come tax time. If you sold any investments for a loss, you should include those in your tax return to offset any gains you may have had. 

For example, if you sold stock A for a $20,000 profit but sold stock B for a $5,000 loss, you’d only owe capital gains tax on the $15,000 in overall profit by including both in your taxes.

Determine Your Cost Basis 

When you’ve purchased shares of the same stock or mutual fund at different times and prices, you’ll need to determine your cost basis for the shares you sell. Several methods can be used: last in, first-out (LIFO), dollar-value LIFO, specific share identification, and average cost (only for mutual fund shares).

If you’re selling a large amount of share, consult with a tax advisor to determine which method will reduce your capital gains tax the most.

Time Your Selling

When it comes to selling stocks, timing can be a significant factor in paying capital gains taxes as well. I’m not just talking about long term vs. short term investments. There could be a time in your life when you face financial hardship or have less income coming in for various reasons. When you have less income could be a better time to sell your investments as you should be in a lower tax bracket.

Calculate Your Capital Gains On Your Home Sale Correctly

When it comes to determining the capital gains on your home, there is a little more to it than you might think. A good starting point is taking your sale price and subtracting your original purchase price. However, you can deduct some closing costs, sales costs, and the property’s tax basis from your taxable capital gains.

Closing costs and sales costs are typically easy to determine and are straightforward. The significant savings comes from the tax basis. Your tax basis is the cost of any substantial improvements you made to your home while owning it. Anything that added value to your home can be considered. However, it is reduced by any depreciation in that structure. For example, if you added a sunroom but then let it fall apart.

To put this into practice, let’s say that you are single and bought a house for $150,000. You sell it for $500,000, and you have the following costs:

  • $15,000 in renovations
  • $25,000 in broker’s fees
  • $1,500 spent selling costs (cleaning, staging, advertising, etc.)
  • $3,000 on closing costs.

You would calculate your taxable capital gains as:

$500,000 – ($150,000 + $15,000 + $25,000 + $1,500 + $3,000) = $305,500

However, you still need to take the special exclusion of $250,000 into account, so you final tax bill would be as follows:

$305,500 – $250,000 = $55,500

You would owe taxes only on $55,500 of capital gains. But, as you can see, if you had merely done the sale price and subtracted the original purchase price and the exclusion, you’d be paying taxes on much more in capital gains.

How To Avoid Capital Gains Tax – Final Thoughts

It seems no matter how we earn some money, we’re going to owe taxes on that income. It’s somewhat of an inevitably. However, that doesn’t mean there aren’t things we can do to reduce those tax bills. When paying capital gains tax, use some of the strategies above to maximize how much of your money you get to keep.