In the recent past, the gains realized from the sale of capital assets held over the long term have been calculated and taxed at a lower rate than ordinary income. The capital assets include the sale of an investment property, stocks, bonds, collectibles, and a primary residence.
The purpose of this blog is to explain the event of a realized gain upon the sale of a capital asset and the calculation of the tax.
Definitions
It is important to know that realized gains from the sale of a capital asset held over a short term are taxed as ordinary income. A short-term hold is the time period measured one year or less. Any gains realized from the sale of a short-term asset will be taxed at the same rate as wages, interest, and unemployment compensation.
However, gains realized from the sale of a capital asset held over the long term, meaning longer than one year, will be subject to a tax calculated at a lower rate. Unlike the federal income tax rate, the calculation of the capital gains tax is not linear. The tax brackets for the capital gains tax are based on filing status and taxable income thresholds.
The tax code enacted these income thresholds and rates to incentivize investments to stimulate the economy.
The Capital Asset
A capital gain is the profit from the sale of a capital asset. The tax is not due until the asset sells. There is no tax due on any appreciation or improvement during the hold period.
Investors of residential real estate held for investment with the fix-and-flip objective need to be careful. If the purchase and the sale transactions are made too often, then these capital assets will be defined as inventory in the eyes of the IRS. The sale of inventory, like assets over a short-term hold, are taxed as ordinary income.
The Capital Gains Tax Rate
A realized gain is when the sale price is greater than the purchase price. The lower rate of the capital gains tax applies when the asset is owned long term, meaning longer than one year. There are three brackets applied to capital gains:
- 0%, 15% and 20%
The applicable rate will depend upon the taxpayer’s filing status and taxable income.
For 2022, the thresholds for taxable income and the corresponding filing status are given below.
| 0% | 15% | ||
|---|---|---|---|
| Single | $41,675 | Single | $459,750 |
| Married Filing Joint | $83,350 | Married Filing Joint | $517,200 |
| Head of Household | $55,800 | Head of Household | $488,500 |
| Married Filing Separate | $41,675 | Married Filing Separate | $459,750 |
If the taxable income is over the 15% threshold, then the tax bracket is 20%. The maximum tax rate for corporations is 21%.
The 1041 Exchange
In the 1990s when the maximum capital gain tax rate was 28% for individuals and 35% for corporations, sales of capital assets were structured as a 1041 exchange to defer the payment of the tax.
Simply defined, one capital asset was traded for another at the sale. Under this structure, an investor did not realize a gain, meaning no cash. In today’s tax climate when the rates for the tax are relatively low, this 1041 sale structure is rarely used.
A 1041 exchange adds an intermediary tier to the sale with much higher closing costs. With the tax levels and the income thresholds in place, the added costs are not justified when compared to the tax rates.
The Principal Residence Exclusion
A principal residence is a capital asset, and the sale of this asset may trigger a capital gain. Fortunately, by way of the Tax Relief Act of 1997, many homeowners are exempt from the capital gains tax under certain conditions.
If a taxpayer is a single filer, then the first $250,000 of a realized gain is not taxed. If taxpayers file jointly, then the first $500,000 of a realized gain is not taxed. This exclusion is not based upon the sale price, but on the gain or the difference between the purchase price and the sale price.
For this exclusion to apply, the home must have been owned and used as a principal residence for at least 2 years.
As with any IRS rule, there are exclusions, adjustments, and exceptions. The calculation of a realized gain and the application of the tax rate are complicated and not as straightforward as described in this blog.
The purpose of this blog is to give an overview, of the definition of a capital gain and the determination of the tax bracket relative to the gain.
It is our hope these goals were accomplished.
Looking for Guidance and Advice on Capital Gains? Contact the Highly Reputable Tax Professionals at Anderson Bradshaw Tax Consulting Today
The tax relief professionals at Anderson Bradshaw Tax Consulting can help with any tax situation. With over 30 years of experience in the industry, we have seen almost every tax issue and have learned the best ways to handle each situation. You can feel confident knowing your struggles and difficulties with the IRS can be resolved and corrected quickly and efficiently at Anderson Bradshaw. For further information and/or to schedule a consultation, please contact AB Tax Consulting at 877.550.3911 or visit www.AndersonBradshawTax.com to learn more.
