Investors contemplating selling their assets need to consider capital gains tax, which can substantially diminish the realized profit from the sale of their investment, depending on their tax bracket and how long they hold the asset. Previously, seniors could benefit from a capital gains exemption, but now, everyone must pay capital gains tax on capital asset sales. If you are nearing retirement or thinking about modifying your investment strategy as you age, familiarizing yourself with capital gains tax can aid you in creating a tax-efficient investment plan.
What Is a Capital Gains Tax?
Investors are subject to the capital gains tax, a tax imposed on any profits they make when selling a capital asset. Capital assets include a diverse range of investments, such as real estate, stocks, bonds, digital assets, precious metals, and jewelry. If you sell any of these investments for a price higher than your adjusted basis in the asset, you will incur capital gains. The asset’s cost basis is adjusted for any events that occurred during its ownership. The Internal Revenue Service (IRS) taxes these gains in the same way as ordinary income.
Capital gains can be either realized or unrealized. If the value of an asset you purchased is worth more than what you paid for it, but you have not sold it yet, you have an unrealized gain. You will have realized capital gains once you sell the asset and make a profit. However, if you sell an asset for less value than your adjusted cost basis, you will have a realized capital loss instead of a realized capital gain.
The capital gains tax rates differ based on the duration for which the owner held the asset. If an investor holds an asset for more than one year before selling it, the capital gain is considered long-term by the IRS. Any capital gains from selling an asset or property held for one year or less are classified as short-term.
The long-term capital gains tax rates can vary from 0% to 20% of the realized profit from the sale, based on income and tax filing status. The short-term capital gains taxes can range from 10% to 37%. A capital gains tax calculator can be used to determine the tax amount that investors owe on the sale of a real estate property.
Capital Gains Taxes Are Unaffected by Investor’s Age
An investor’s age does not have a direct impact on the capital gains taxes they are required to pay upon selling an asset. However, there are other methods to reduce your capital gains tax liability. The duration of your investment can have a significant effect on the capital gains you owe. If you hold a property for at least a year, you are subject to long-term capital gains taxes, which may be lower than short-term capital gains taxes based on your tax bracket.
To further reduce their tax liability, some investors leverage capital losses, which result from selling an asset for less than its adjusted cost basis. By offsetting their taxable capital gains with total capital losses incurred during the year, taxpayers can claim a deduction on their taxes for the total net loss or $3,000, whichever is lower. If the loss exceeds $3,000, taxpayers can carry it over to future years.
To avoid any tax-related complications, investors need to seek guidance from a tax consultant before buying a property and during the selling process. This will help them understand how capital gains tax could impact their investment and make informed decisions.
Capital Gains Taxes and Seniors
While capital gains tax is typically unavoidable, there is a way to potentially receive an exemption by utilizing a tax-advantaged retirement plan. If you have a specific type of retirement account and meet the requirements for taking distributions, you may be able to skip paying capital gains tax on eligible withdrawals.
During retirement, people often rely on two main sources of income: retirement account distributions and Social Security payments. The IRS applies different tax rules to retirement accounts depending on their type. For instance, traditional Individual Retirement Accounts (IRAs) don’t get taxed until you make a withdrawal. These accounts offer front-end tax benefits by letting your investments grow tax-free. However, once you begin taking distributions, the funds become fully or partially taxable and may be subject to capital gains taxes.
On the other hand, a Roth IRA functions differently from traditional IRAs. These accounts are back-end tax-advantaged, meaning you pay taxes on contributions upfront. The advantage of having a Roth IRA is that eligible distributions are tax-free. By using a Roth IRA, you could potentially take withdrawals during retirement and steer clear of paying capital gains taxes on any gains made by your account.
This creates a type of exemption from capital gains tax that solely pertains to individuals who are eligible for qualified distributions. A qualified distribution from a Roth IRA usually occurs after the account owner turns 59 ½ years old or after a five-year period from the initial contribution.
Deferring Capital Gains Taxes By a 1031 Exchange
If you’re looking to defer capital gains tax on real estate, one option is to execute a 1031 exchange. This exchange is a tax-deferred transaction authorized under Section 1031 of the Internal Revenue Code, which permits investors to utilize the proceeds from selling one investment property to buy another. By performing a 1031 exchange, investors can defer paying capital gains tax on the sale of their property.
Assuming the investor acquires a replacement property that equals or exceeds the value of their relinquished property, they can defer taxes indefinitely until they sell a property without executing a 1031 exchange. Provided that they adhere to the rigorous exchange regulations, there is no restriction on the number of 1031 exchanges an investor can conduct. If the investor passes away, any deferred capital gains taxes are eliminated, and the properties are passed down to their heirs at the fair market value at the time of the investor’s death, resulting in a step-up basis.
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