Series 2: When are Capital Gains Taxed and How to Calculate

October 27, 2022

Capital gains are taxed when they’re “realized.” Your capital gain (or loss) is generally realized for tax purposes when you sell a capital asset. As a result, capital assets can continue to appreciate (increase in value) without becoming subject to tax as long as you continue to hold on to them. For example, loans against your capital asset don’t give rise to a realization event or capital gains tax. For this reason, many real estate investors will refinance properties rather than sell them.

Other types of events besides sales can also give rise to a “realization.” For instance, property that is involuntarily converted or taken by the government, or over which you grant an exclusive use right to others, may be treated as sold. A capital gain (or loss) is also realized when property is exchanged for other property.

Although the exchange of property generally is a taxable realization event, special rules apply to “like-kind” exchanges of real estate. Among other requirements, the rules require you to find a replacement property within a certain timeframe, but they may help reduce or eliminate your taxable gain.

Your taxable capital gain is generally equal to the value that you receive when you sell or exchange a capital asset minus your “basis” in the asset. Your basis is generally what you paid for the asset. Sometimes this is an easy calculation – if you paid $10 for stock and sold it for $100, your capital gain is $90. But in other situations, determining your basis can more be complicated.

Tax Tip: Since your basis is subtracted from the amount you receive when disposing of a capital asset, you want the highest basis possible so that the taxable portion of your profit is as low as possible.

If you sell some but not all the stock you hold in a company, and you acquired stock on different dates, there are several ways to determine your basis. Usually, the first-in-first-out rule applies (i.e., stock you purchased first is considered sold before stock you purchased later). However, the basis might instead be determined by specific identification and matching of each share you bought and sold. You may also elect to use the last-in-first-out rule (i.e., stock you purchased last is considered sold before stock you purchased earlier) or the average cost basis for all shares sold. Given these differences, if you acquired stock on different dates (e.g., through a dividend reinvestment plan), make sure you pay close attention to your method of accounting before selling down your position.

Basis calculations are also more complicated if you acquired the capital asset you’re selling other than by an ordinary purchase. For example, if you inherit an asset, you generally take a “stepped-up” basis (i.e., the asset’s fair market value at the date of the previous owner’s death). If someone gives you a capital asset as a gift, the donor’s basis carries over to you. If you receive stock from your employer as part of your compensation, your basis is generally equal to the amount included in your taxable pay (i.e., reported on your W-2) allocated to the securities.

Your basis can also include more than simply your initial purchase price. For example, your basis can also include expenses related to buying, selling, producing, or improving your capital asset that are not currently deductible. This will reduce your gain when you sell. Home improvement expenses, and brokers’ fees and commissions that are clearly identified with a particular asset can raise your basis. Just make sure you keep receipts and other records related to these additional costs. Also note that certain investment-related expenses are miscellaneous itemized expenses and disallowed through 2025 (nor will these expenses increase your basis).

The amount of capital gain subject to tax can also be reduced if an exclusion applies. Perhaps the best-known capital gains tax exclusion is for the first $250,000 of gain ($500,000 if filing jointly) from the sale of a personal residence you’ve owned and lived in for two of the last five years. In addition, 100% of your gain from the sale of “qualified small business stock” may also be excluded if you acquired the stock after September 27, 2010. If the stock was purchased before that date, you still may be eligible for a partial exclusion of either 50% or 75% of the gain.

Various other actions can impact your basis or the calculation of capital gain. These include, among other things, granting an easement over land you own, taking depreciation deductions for wear and tear on your property, or selling property for less than fair market value (i.e., a “bargain sale”). When more complicated situations like these arise, it’s best to seek a tax professional’s advice before selling or exchanging the related capital asset.

Source: Kiplinger