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Home»Taxes»What is Capital Gain Tax and how does it work?
Taxes

What is Capital Gain Tax and how does it work?

Biz GeldBy Biz GeldFebruary 16, 2022Updated:June 6, 2022No Comments7 Mins Read
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Capital Gain Tax is the tax you pay on the profits made by selling your stocks, shares, precious metals, real estate properties, and other taxable assets. In simple words, when you sell any such asset, you pay such tax on the profit that your investment has made. These taxes vary from country to country. But in most countries, it is around 15% – 20 % of the total profit.

Whether it is stock, share, or any other form of trading, it is difficult to evade taxes. Governments worldwide need to collect revenue from their citizens to run a stable economy, and taxes are a way of doing so. As a result, tax experts assess different spheres of financial activities.  You can read more about income taxes here. OR you can check the most frequently asked questions about taxes here.

For example, if you sell your home after having been its owner for more than two years, you need to pay Capital Gains Tax on the profit you have made by selling it.

It is important to understand these taxes to know how they work and how you can reduce what you end up paying. But before learning how to minimize these taxes, it is essential to know;

  • The two types of capital gain tax
  • Incomes that are taxable under this tax system
  • How to calculate these taxes
  • Six ways to avoid or minimize the payment of these taxes
  • And most frequently asked questions about taxes on capital gains.

Types of Capital Gain Tax:

There are two types you need to know about when you sell any taxable asset.

1. Short-term capital gain tax: If an asset such as property, stocks, or real estate is sold before one year of the date of purchase, then it will be considered as a short-term capital gain. The profit is added to your income, and you need to pay taxes according to the tax slab rate for this particular income.

2. Long-term Capital Gain Tax: If an asset is sold after at least one year of purchase, it will be considered a long-term capital gain. In this case, the profit is added to your income, and you need to pay taxes according to the tax slab rate for this particular income.

Incomes that are taxable under Capital Gain Tax:

The following types of incomes are subject to Capital Gain Tax

  1. Sale of primary residence
  2. Sale of other real estate property. >> More details on property tax.
  3. Stocks, bonds, ETFs, Mutual funds, etc.
  4. Precious metals like gold and silver
  5. Royalty payments made to non-residents for copyrights or trademarks used in India

How to calculate Capital Gain Tax?

To calculate this Tax, you need to know a few terms:

1. Final sale price: This is the total amount received by you from the sale of taxable assets such as real estate, stocks, and so on.

2. Cost of acquisition: This is the total amount that you paid for buying taxable assets such as real estate, stocks, and so on.

3. Cost of improvement: If you have improved the asset, it will increase its market value. The proportion of the improvement cost and final sale price is considered the actual gain.

4. Transfer cost: This is the cost that you incur to sell your taxable assets. This includes brokerage, legal fees, etc.

5. Index cost of acquisition: This is the acquisition cost if you had to repurchase your taxable asset.

6. Index cost of improvement: This is the cost of improvement if you had to buy your taxable asset again.

How to calculate short-term Capital Gains Tax? Short-term capital gain = Final sale price – (The cost of acquisition + Cost of improvement + Transfer cost)

How to calculate longterm Capital Gain Tax? Long-term capital gain = Final sale price – (Indexed cost of acquisition + Indexed cost of improvement + cost of transfer)

You can use this free capital gain tax calculator from SmartAsset to see how your gains could be impacted.

Six Ways on How to Avoid Capital Gains Tax

There are many ways you can avoid or minimize these taxes legally. Here are a few of them:

1. Invest in the long term:

Whenever you invest in stocks or any other taxable asset for that matter, make sure to hold them for at least a year. This way, your capital gains will be considered long-term, and you won’t have to pay short-term capital gains tax on it. Short-term capital gains are higher-taxed compared to long-term capital gains.

2. Use tax-deferred retirement plans:

To avoid capital-gain tax, you can use tax-deferred retirement plans like the traditional IRA or 401(k). An example of this is that if you have bought some stock that has now appreciated, you can sell it and reinvest the money in a Roth IRA. That way, your investment will grow tax-free throughout your lifetime.

3. Pick your cost basis:

You can choose a “specific identification” cost basis to avoid capital gains tax. This way, you will be able to sell the taxable asset that has been appreciated at a lower price and reduce your capital gain amount.

4. Buy tax-exempt bonds:

You can buy municipal bonds, which are exempt from federal income tax. This way, you won’t have to pay federal income tax on interest earned from it. Since capital gains are taxed at both the federal and state level, avoiding this tax can help you keep more money in your pocket.

5. Take advantage of capital losses:

Suppose you have incurred a capital loss from selling another asset. In that case, you can use it to offset the amount of capital gain that you would have to pay on profitable assets. You can carry forward the unutilized capital losses to future years and use them against future capital gains.

6. Donate:

The best way to avoid taxes on your capital gains is by donating to qualified charities. If you donate to a qualified charity, the value of the item given will be added to your gross income for that year. However, you can reduce your taxable income by the amount of donation you made to a charity.

Related Article: A Free Guide On Tax Relief and how to handle it.

Six Common FAQ On Capital Gain Tax

1. What is the rate of short term capital gain tax? Short-term capital gains are taxed according to the tax brackets that you fall in. It is around 15% – 20%.

2. What is the rate of longterm capital gain tax? Long-term capital gains are currently taxed at 10%-20%, depending on your assets and investment period.

Read more about Types of investments you should know about.

3. Which properties are not taxable under Capital Gain Tax? You won’t be taxed for capital gains on your primary home if you have used it as a personal residence at least two years in the last five years before its sale.

4. What would happen if you don’t report capital gains? If you don’t report taxable capital gains, you will face a penalty or even prosecution in extreme cases.

5. What would happen if you report a wrong gain? If you file a fake capital gains tax, you will have to pay them back in addition to a penalty of up to 25% of the amount of tax owed. You can be prosecuted for perjury or filing a false return too.

6. Do I need a CPA to file my taxes? You don’t need a certified public accountant (CPA) to file your taxes. However, you would benefit from their services by getting tax advice and guidance about various deductions. You can also hire CPAs if you want them for professional tax planning or representation when it comes time to do your taxes.

Bottom-Line:

There you have it! These are the basics of capital gains taxes. Don’t be intimidated by it. If you want to avoid paying high taxes on your profits, take advantage of all these helpful tips and tricks! The best idea would be to consult a professional tax advisor, but if you must do it yourself, well, this is all the knowledge you need!

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BizGeld provides well-researched and free finance educational content to help you make informed financial decisions. Although we provide unbiased information and recommendations, we are not your typical financial advisor. So before making any financial decision, please contact a professional.

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