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What You Need to Know About Capital Gains Taxes

This year, a surprisingly large number of people are asking about capital gains taxes for the first time.

2020 marked the 47th recession in the history of the U.S., and our first since the 2007-09 “Great Recession.” The National Bureau of Economic Research hasn’t officially pegged an end date to the COVID recession, but we do know that it involved an estimated 3.4% decline in gross domestic product (GDP) and national unemployment of 14.7% at its worst.

Despite this and a lightning-quick bear market, Wall Street is flush with a slew of fresh investors. Consider this Detroit Free Press report:

“More than 10 million new brokerage accounts were opened by individuals in 2020 — more than ever in a year, according to an estimate by Devin Ryan, equity research analyst at JMP Securities,” writes the Free Press’ Susan Tompor.

Many of those new investors were enticed by a “perfect storm,” Ryan says. This included zero commissions, a large stock market dip to buy, and for some, a stimulus check that didn’t have to go toward daily needs.

Quite a few of those investors ended 2020 with plenty of capital gains. That’s great, but like most other income, remember: Uncle Sam wants his cut. So read on as we discuss capital gains taxes.

The Basics of Capital Gains Taxes

Capital gains taxes are taxes you pay on the realized profit from an investment in a given year. That goes for stocks, bonds, real estate, even a precious metal such as gold or silver.

“Realized” is the key word here. You have to sell the investment and lock in that profit for capital gains taxes to apply. If you owned stock that went up in 2020, but you didn’t sell it, you’re off the hook.

You’re also off the hook if you realized profits in a 401(k) or an IRA, which are “tax-advantaged” accounts. However, if you just have a traditional brokerage account, capital against taxes apply.

How Much Tax Do I Have to Pay?

Your capital gains tax rate hinges on two factors: 1.) your taxable income, and 2.) how long you held the investment.

If you hold an investment for at least one year, you’re privy to special “long-term” capital gains tax rates of 0%, 15% or 20%. The IRS provides a full list of scenarios here, but as a for-instance, let’s look at a single filer. The long-term capital gains rate for the 2020 tax year is 0% for single filers with taxable income up to $40,400, 15% for those earning between $40,401 to $445,850, and 20% for those making more than $445,850.

However, if you lock in gains on investments you’ve held less than a year, that’s a short-term capital gain, and it’s subject to ordinary tax rates. The IRS provides the various rates here, but in short, you could be taxed between 10% and 37%, depending on your situation.

Capital Losses

If you weren’t so lucky on your investments in 2020, or if you ever face a difficult spell in the future, you might be able to declare a capital loss on your tax return.

Tax filers can deduct up to $3,000 in capital losses against their earned or other income in any given year. If you realize $6,000 in capital losses in a year, you still can deduct only $3,000 from that year’s taxes. However, you can carry the remaining $3,000 forward and deduct it from your income the next year.

You can also net capital losses against capital gains.

Let’s say you realize $23,000 in capital losses in 2021, and deduct $3,000 of that against your 2021 taxes. Even though you’d have $20,000 in carry-forward losses, you’d still only be able to deduct $3,000 from your taxes in 2022 and each year after that. However, if you recognize $20,000 in capital gains in 2022, you can offset those gains with the $20,000 carry-forward losses. And thus, you are left with no taxable capital gains.

Expert Tax Advice From McManamon

The tax professionals at McManamon & Co. specialize in small to midsize businesses operating across a broad spectrum of industries. If you’re a business owner looking to make better sense of your tax situation, or improve your tax strategy to maximize deductions and credits, call us at 440.892.9088, or contact us online.

And no matter who you are, if you’re just looking to improve your tax knowledge, check out our other blog posts.

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