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At the end of the year, many questions tax professionals receive often pertain to capital gains and losses in their portfolios. Can they offset each other? Are there specific conditions? Does it matter how long you’ve owned a property? Let’s talk about it.
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Tax Implications for Realizing Capital Gains and Losses
Short-Term Capital Gain
Short-term capital gains are profits realized from the sale or transfer of a capital asset (like real estate property) that has been held for 12 months or less. A short-term capital gain is the difference between the purchase price and the asset’s sale price. Profits are taxed as ordinary income at a taxpayer’s marginal tax rate, with the highest bracket coming in at 37%.
For investors subject to the net investment income tax (NIIT), an additional 3.8% is added, possibly bringing the tax rate to 40.8%. If you include state and local income taxes, this rate can be closer to 45%. Long-term capital gains have lower federal tax rates and are preferred for many investors.
Long-Term Capital Gain
Long-term capital gains are profits realized from the sale or transfer of a property that has been held for more than 12 months. As of 2021, federal capital gains rates fall into three brackets depending on income level: 0%, 15%, and 20%.
Long-term gains are often preferred for investors as the tax rate tends to be much lower than marginal bracket rates used for ordinary income and short-term gains.
What’s a Stock Loss?
A stock loss occurs when money is lost from selling a stock for less than its original purchase price. Stock losses can be deducted against ordinary income or capital gains realized in the same tax year.
How Does Losing Money in the Stock Market Affect My Taxes?
Realized losses from stock sales can be used to reduce your tax bill at the end of the year. The IRS currently limits net capital losses to $3,000 annually. Any additional losses beyond the $3,000 can be claimed under the carryover rule in future years. In addition, if you don’t have any capital gains to offset losses, the loss may be used to offset ordinary income - also up to $3,000.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the strategic selling of stocks, often towards the end of the year, to offset a tax obligation either on capital gains or their regular income. In other words, investors can sell off some of their poor investments at the end of the year and get a tax break in return. The tax-loss harvesting method is a heavily-used strategy for lowering the annual tax burden for many serious investors.
According to the U.S. federal tax law code, both short and long-term losses must be first used for offsetting gains of the same loss type. For instance, short-term capital losses must be used to offset any short-term gains within the same tax year before offsetting long-term gains. When looking for stock losses, focusing on short-term losses may offer the most significant benefit come tax time since they will first be used to offset any short-term gains taxed at the higher ordinary income rate.
To claim a qualifying loss, investments must be sold in taxable accounts prior to the end of the calendar year. Losses are then reported when taxes are filed at the beginning of the following year.
The Internal Revenue Service currently allows a maximum net capital loss of $3,000 to be claimed each year against ordinary income for married filing jointly and single filers. Any losses surpassing $3,000 can be claimed in subsequent tax years to offset future gains. Due to the capital loss tax deduction and carryover rules, realizing a capital loss may still be an effective investment strategy even if you didn’t have any capital gains this tax year.
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Example of Tax-Loss Harvesting
To help explain when the tax-loss harvesting principle could apply, let’s take a look at a real-world example.
Sanjay currently sits in the 24% tax bracket based on his income. Sanjay purchased $100,000 of an index fund in one of his taxable accounts at the beginning of the year. In November, its value had decreased to $93,000. Sanjay sold the $93,000 worth of stock to obtain a $7,000 capital loss for tax-harvesting. He then used the sale proceeds to purchase a similar, but different, index fund as a replacement in his portfolio.
The $7,000 capital loss would offset any capital gains Sanjay realized in the same tax year. If his losses surpassed his gains, up to $3,000 of the net loss could be used to offset Sanjay’s ordinary income. Since his income falls into the 24% tax bracket, this would reduce his income tax by $720. Any additional losses beyond the $3,000 can be claimed in subsequent years under the carryover rule.
What Are Capital Gains Taxes on Real Estate?
Under current U.S. federal tax policy, capital gains tax rates apply to profits earned from the sale of properties held for more than 12 months. Capital gains taxes on real estate are only due for payment after a property is sold, not when it is purchased. For those looking to sell a real estate property, it may be preferable to delay the sale until after one year has passed.
If a real estate sale occurs before 12 months of ownership and profits are earned, the profits will be taxed at the seller’s ordinary income marginal tax rate under the short-term capital gains rule. Depending on income level, tax rates on ordinary income may be as high as 37%, not including state and local-level assessments. Capital gains tax brackets are much lower, with 15% and 20% as the most commonly assessed rates. The tax rate charged depends on the taxpayer’s income bracket for that year.
How Do Real Estate Capital Gains Effect My Taxes?
Determining how much you will owe in capital gains taxes can be a bit complicated. Marital status, property type (investment or primary residence), personal tax bracket, and length of time you’ve owned the property are all determining factors when calculating how much your tax bill will be.
If you’ve owned the property less than a year, sale profits will be considered short-term capital gains and subject to ordinary income tax. If you are a high earner, this may be 37%. When given a choice, it may be more strategic to wait until you surpass 12 months to sell. After a year of holding, profits from the sale then falls under the long-term capital gains category reducing applicable tax rates to 15 or 20% depending on income level. In both short and long-term gains, taxes are only assessed on the profits earned.
It is important to keep in mind that most states add an additional state and local-level capital gains tax in addition to federal rates. Since each state uses its own method of calculating tax bills, it’s important to look up current rates for your local area.
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Can the Two Offset Each Other?
Absolutely. When an investor experiences short or long-term losses from stock trades, these losses can be used to offset capital gains in other areas like real estate sales. In most instances, it may be beneficial to hold on to a property for at least 12 months for tax purposes to shift tax obligations from ordinary income rates to capital gains rates depending on your individual situation. Keeping meticulous records of all gains and losses is crucial and will help your accountant settle the score come tax time.