What You Need To Know About The Capital Gains Tax In 2014

By Christina T. Vidoli 

When you sell property for more than you paid to buy it, the profit is known as “capital gain.”  Like ordinary income, the capital gain you receive is subject to taxes, but at the federal level the rates are different from those on your earnings from work or from interest and dividends.  The capital gains tax rate depends on your overall taxable income, the length of time you’ve held the property, and whether you took offsetting losses to charge against some or all of your gain.

Basis

To start off with the basics, capital gain (or loss) is the difference between what you receive for the sale of property and its “basis.” The basis is the amount you originally paid for the property, but it can be adjusted in two ways. First, if the property is real estate, you can add to the basis the costs of improvements. For instance, if you bought a house for $300,000 and spent $100,000 putting on an addition, the new basis will be $400,000 ($300,000 + $100,000). 

The second adjustment has to do with inherited property. If the house was actually purchased by your parents and you inherited it from your mother, the new basis would be the value on her date of death. If by then, the value had grown to $600,000 and you sold the house for that amount, you would have no gain and no tax would be due. If, on the other hand, your mother transferred the house to you during her life as a gift, you would have received it with her basis -- known as a "carry over" basis -- of $400,000 and realized $200,000 of gain upon its sale for $600,000.

These rules also apply to shares of stock and other capital items, such as furniture and artwork. It's often better to receive these as an inheritance rather than as a gift, especially given the higher capital gains tax rates on collectibles discussed below.

Personal Residence Exclusion

You may be able to exclude some or all of the gain that is taxed on the sale of your personal residence.  The  tax code permits owners of homes to exclude up to $250,000 of capital gain ($500,000 for a married couple) if they have owned and lived in their home for at least two years out of the five years before a sale.  So, if your mother transferred her house to you as a gift and then you moved in for at least two years prior to its sale, then you wouldn't have to pay taxes on the $200,000 of gain.

The Tax Rate 

Once you determine the amount of gain, the hard part comes, and it’s gotten much harder in recent years.  Short-term gains (those assets that are owned for less than one year before their sale) are taxed at your ordinary income tax rates.  Long-term gains (those assets owned for at least one year plus one day) usually have tax rates that are less than ordinary tax rates and depend on your overall income tax bracket.    

Following are the federal tax rates for both types of capital gain:

Tax Rates for the Year 2014

 

Taxable Income

Married

Taxable Income

Single

Ordinary (Short-term Gains Tax Rate)

Long-term Gains Tax Rate

$0 - $18,150

$0 – 9,075

10%

0%

 

$18,150 – 73,800

$9,075 – 36,900

15%

0%

 

$73,800 – 148,850

$36,900 – 89,350

25%

15%

 

$148,850 – 226,850

$89,350 – 186,350

28%

15%

 

$226,850 – 405,100

$186,350 – 405,100

33%

15%

 

$405,100 – 457,600

$405,100 – 406,750

35%

15%

 

$457, 600 +

$406,750 +

39.6%

20%

 

Collectibles for all income brackets

28%

 

Under the American Taxpayer Relief Act of 2012, the top federal capital gains tax rate was raised from 15 to 20 percent for taxpayers with taxable income greater than $400,000 for single filers and $450,000 for joint filers. (These thresholds are adjusted each year for inflation.) This higher capital gains rate applies only to the gain that when added to other taxable income, exceeds the threshold amounts.  In other words, for purposes of determining the appropriate threshold, capital gain is included as taxable income. Taxpayers who are below the 39.6 percent taxable income threshold before capital gains are taken into account will have their capital gains taxed at 15 percent up to the taxable income threshold and 20 percent on the excess.  Here are two examples of how this works:

Example 1.   Married taxpayers earn $400,000 of ordinary income and another $200,000 in net capital gains.  Under the new law, the first $57,600 of capital gains is taxed at the lower rate, with the remaining $142,400 taxed at the higher rate.  The effective rate of 18.75% reflects the blending of the 15% and 20% rates.

Income Type

Amount

Tax Rate

Ordinary Income

$400,000

 

Net Capital Gain

$200,000

 

Taxable Income

$600,000

 

39.6% Threshold (Jt. Filers)

$457,600

 

Net Capital Gain < Threshold

$57,600

15%

Net Capital Gain > Threshold

$142,400

20%

Effective Capital Gain Tax Rate

18.6%

Example 2.  Married taxpayers now earn $200,000 of ordinary income and another $400,000 in capital gains.  Because a greater portion of the taxpayers’ taxable income has shifted from ordinary income to net capital gain, the effective net capital gain rate is lower than the previous example because a greater portion of the taxpayer’s below-the-threshold income is taxed at the 15% rate, leaving a smaller remainder subject to the 20% tax.

Income Type

Amount

Tax Rate

Ordinary Income

$200,000

 

Net Capital Gain

$400,000

 

Taxable Income

$600,000

 

39.6% Threshold (Jt. Filers)

$457,600

 

Net Capital Gain < Threshold

$257,600

15%

Net Capital Gain > Threshold

$142,400

20%

Effective Capital Gain Tax Rate

16.78 %

Medicare Surtax

In addition, the capital gains of high-income earners are subject to a new 3.8% Medicare surtax on capital gains (and other net investment income) imposed by section 1411 of the Internal Revenue Code,  above and beyond that capital gains tax rate.  This 3.8 percent Medicare surtax applies to taxpayers with net investment income who exceed threshold income amounts of $200,000 for single filers and $250,000 for married couples filing jointly.  Net investment income includes interest, dividends, capital gains, retirement income and other forms of unearned income. 

In the above examples, because the income threshold for the surtax is lower than the 39.6% tax rate threshold ($200,000 for single filers and $250,000 for joint filers), the surtax would apply to the entire net capital gain amounts in both examples, resulting in an effective tax rate on the capital gains of 22.4% and 20.58% respectively.

State Taxes

Most states also charge taxes on capital gains.  In Massachusetts, the tax rate is 5.25 percent on both short and long-term capital gains, except on collectibles, which have a tax rate of 12 percent.  So, for Massachusetts residents the combined tax rate on collectibles can be as high as 43.8 percent, a strong argument for passing them on o heirs through one’s estate rather than as a gift during life, since this will give them the so-called “step-up” in basis.

“Harvesting” Gains and Losses

For those in a lower income tax bracket, it can make sense to "harvest" gains every year by selling some stock, but not so much that it pushes you into a higher bracket. If you really do want to own the stock, you can always buy it back again after its sale with the new basis being the purchase price. For example, if you own stock worth $40,000 for which you paid $10,000, it has gain of $30,000.  If you sell it before the end of the year and your other taxable income is below $40,000 (for a couple) you will have to pay no tax on the gain. If you subsequently repurchase the stock for $40,000, that will be its new basis, permitting you to sell it in future years with less concern about the tax consequences. (But don't sell it too fast; if you sell it within a year of purchase it will be treated as short-term capital gains and subject to a higher tax rate.)

Individuals should also consider selling property that has dropped in value as a way to harvest losses and offset any gains. 

Conclusion

In short, the tax rate on capital gains depends on the type of property being sold, how long it's been owned, whether or not it was inherited, and the other income of the seller. All of this means there are planning opportunities for those with property containing gain. It’s important to consult with an accountant or attorney for strategies to lessen the bite of capital gains or bypass them altogether.  Otherwise, you could be in for a surprise capital gains tax bill the next time you file your tax return.

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