How capital gains tax on investments works

When you start investing, you might be excited about the potential for growth over time and benefits to you, your family and the causes you support. But you should be aware that certain investments may be taxed based on their growth.

The capital gains tax on investments comes into play when an investment's value increases between the time it is bought and the time it is sold. When you sell at a profit, you may be required to pay this tax. Understanding the ins and outs of this tax, including who pays the capital gains tax, can help you better manage investments. Here's what you need to know.

Capital gains tax only applies to the sales of capital assets. These items are usually significantly valuable assets, such as:

• homes
• investment properties
• cars
• stocks
• bonds
• art
• other collectibles

The price you pay to purchase an asset is its cost basis. When you sell that asset for more than what your cost basis was, you earn a profit. That profit is what the capital gains tax applies to.

In the event you've inherited something, such as property, rather than purchased it, the cost basis is no longer the asset's purchase price but its value on the date of the death of the person who gave it to you. This is called a stepped-up basis and relieves you of having to pay the tax on the increase in value before it became yours.

You only pay capital gains tax on investments when you sell the investment or item at a profit, which is called a realized gain. When you are merely holding your assets — even if they increase in value under your watch (known as unrealized gains) — you won't owe any capital gains tax yet. After all, the asset's value could decrease before you sell it, so you're not taxed until you sell it and make a profit.

The capital gains tax is levied for the tax year in which you sold your investment. You can report capital gains using IRS Form 1040, Schedule D, Capital Gains and Losses.

Capital gains taxes cover your investment sales as a whole. In other words, you pay capital gains tax only on net capital gains, which means you deduct your capital losses from them before the tax is calculated.

A capital loss occurs when you sell an investment for less than your cost basis. You can offset capital losses against capital gains for similar investments. For example, if you sell one stock at a loss but another at a gain, the loss is deducted from the gain to determine your net capital gain or loss.

If you had a downward year and had a net capital loss (after applying losses to gains) of up to $3,000, you can deduct that against your other types of income for that year, such as your salary on your taxes, reducing your overall income. If you have capital losses over $3,000, you can carry that forward to future tax years (up to $3,000 per year for married filing jointly and $1,500 for single filers) and reduce your taxable income in those years.

The amount of the capital gains tax depends on how long you owned the asset.

A short-term capital gain applies to an asset you owned for one year or less before you sold it. These gains are taxed at the same rate as your ordinary income, such as your salary. Your federal income tax rate (anywhere from 10% to 37% depending on your tax bracket) applies to the profit you earned on the sale of your investment.

Long-term capital gains apply to assets you owned for more than one year before you sold them. This rate is generally lower than your ordinary income rate. These gains are taxed at 0%, 15% or 20%. The rate is determined by how you file and what your taxable income is:

Capital gains tax on the sale of collectibles is capped at 28%, even if it is a short-term gain and your ordinary income tax rate is higher.

How are dividends on stocks, bonds and mutual funds taxed? Dividends are not taxed as capital gains but instead are taxed at ordinary or qualified dividend tax rates depending on the nature of the dividend-paying security.

If you sell your principal residence, valued at $250,000 per individual or $500,000 for married filing jointly, it's excluded from the capital gains tax if you have owned and lived in it for at least two years. You can't deduct capital losses from the gains on this type of property; however, you can add the cost of repairs and improvements to your cost basis, which may reduce how much gain you are taxed on. You also can add your sales costs to your cost basis.

In addition to capital gains tax, if you have a capital gain from an investment and your modified adjusted income is over the limits, you may need to pay an additional 3.8% tax called Net Investment Income Tax.

To potentially reduce your capital gains taxes, you may want to aim for long-term capital gains, or investments you plan on holding for more than a year, so your capital gains rate likely will be lower than your tax rate on ordinary income, which is the rate applied to short-term gains.

Investing in your residence also can help reduce your capital gains. The improvements and repairs you make can be added to your cost basis, reducing the tax if you sell it. In addition, maintaining an investment until your death and passing it on to your heirs can give them a stepped-up basis so that neither of you has to pay taxes on the capital gains that occurred during your lifetime.

Being aware of capital gains taxes can help you make wise investment decisions that allow you to minimize your tax liability. Connect with a local financial advisor to get help navigating different investment and withdrawal strategies.