Understanding Capital Gains and Losses Taxes

When you sell an investment like stocks, bonds, mutual funds, or real estate for more than you paid, the profit is taxed as a capital gain. Conversely, selling for less than your purchase price results in a capital loss that can be deducted on your tax return under certain rules.

Capital gains and losses can have a major impact on your investment tax liability. This guide will explain what capital gains and losses are, how they are taxed, reporting requirements, strategies to minimize tax, common myths, and key factors investors need to understand to benefit from capital losses while avoiding unnecessary taxes on capital gains.

What are Capital Gains and Losses?

Capital gains and losses are defined as:

Capital Gain – The profit made when selling an investment asset for more than your cost basis (the amount paid to acquire the investment).

Capital Loss – The loss taken when selling an asset for less than your cost basis.

Investments that can generate taxable capital gains and losses include:

Stocks and bonds
Mutual funds and ETFs
Options
Business assets
Collectibles like art and antiques
Real estate like rental properties or second homes

Capital gains or losses are categorized either as short-term or long-term based on how long you held the asset before selling. This distinction affects tax rates.

Short-Term vs. Long-Term Capital Gains Tax Rates

How capital gains are taxed depends on if they are short-term or long-term:

Short-Term Capital Gains

Held 1 year or less before selling
Taxed as ordinary income at your regular income tax rate (up to 37% federal)

Long-Term Capital Gains

Held more than 1 year before selling
Taxed at preferential long-term capital gains rates

For 2022, the federal tax rates on long-term capital gains are:

0% for Single filers with taxable income up to $41,675
15% for Single filers with taxable income from $41,676 to $459,750
20% for Single filers with taxable income over $459,750

Holding assets long-term produces better tax treatment. Short-term gains lose this advantage.

What is Cost Basis?

Your cost basis is your investment in an asset used to determine capital gain or loss upon selling it. Basis includes:

Original purchase price
Commissions and fees on both the purchase and sale
Improvements and additions to the asset while owned
Depreciation previously deducted (for real estate)

Basis essentially equals your investment into the property. The sale price minus the cost basis determines if there is a gain or loss.

For example, you purchase a stock for $10,000 plus a $50 commission. Your cost basis is $10,050. Selling for $15,000 means a capital gain of $4,950 ($15,000 – $10,050).

If you sold for $9,000 instead, the $1,050 loss could be deducted ($10,050 – $9,000).

Accurately tracking basis is crucial to calculate gain or loss correctly on your taxes.

Capital Losses Can Offset Capital Gains

A useful benefit of capital losses is they can be used to offset capital gains taxation:

If you realized both capital gains and losses in a tax year, they are netted against each other on your tax return.
For example, if you had a $5,000 short-term loss and $8,000 long-term gain, they would offset – leaving just $3,000 in net long-term capital gain.
This essentially makes capital losses deductible against capital gains.

If your total net capital losses exceed your total capital gains, you can deduct the excess amount from your ordinary income, up to $3,000 per year. Excess losses carry forward to future tax years.

This makes tracking and recording your investment losses valuable for reducing tax liability.

Claiming Capital Losses on Your Tax Return

You report capital losses you want to deduct on IRS Form 8949. The full process involves:

Calculate your total short-term capital losses and long-term capital losses for the year.
Net short-term gains with short-term losses, and net long-term gains with long-term losses.
If losses exceed gains, use excess losses to offset up to $3,000 of ordinary income.
Carry any remaining unused capital loss forward to future tax years.
Report losses claimed on Form 8949 and carryovers on Schedule D.

Save detailed records of your cost basis and sale records to support capital losses claimed if audited. You must prove the loss amounts.

Capital Loss Carryovers

If your net capital losses exceed your gains for the year, you can use up to $3,000 of the excess to offset ordinary income. Any remaining unused loss can be carried forward indefinitely to future years.

Rules on carryover losses:

Net short-term loss must be used before any long-term loss carryover.
You have an unlimited number of years to use up carryover losses.
Apply the oldest loss carryovers first – losses expire based on the tax year they occurred.
Claim carryovers each year until all unused losses are exhausted.

Carryovers provide flexibility to deduct more losses over time. Just be sure to carry unused amounts forward each year on Schedule D.

Exceptions Where Losses Are Disallowed

While normally deductible, capital losses face some restrictions:

Losses on personal use assets like your home or car are not deductible.
“Wash sale” losses where you buy back the same asset within 30 days are disallowed.
Losses cannot exceed total capital gains. Only $3,000 excess can offset ordinary income.
Inventory and business asset losses are not subject to capital loss limitations and may be fully deductible.
Passive activity loss limits apply, typically $25,000 maximum per year.

These exceptions prevent deducting losses just for tax benefit or shielding active business or portfolio income. Wash sale rules deter quick selling then repurchasing stocks just to harvest tax losses.

How Long-Term Capital Gains Are Taxed

Long-term capital gains (held over one year) receive preferential tax rates compared to ordinary income. For 2022, the long-term capital gains tax brackets are:

0% – For Single filers with taxable income up to $41,675

15% – For Single filers with taxable income from $41,676 up to $459,750

20% – For Single filers with taxable income above $459,750

Those with income exceeding $1 million pay an additional 3.8% Net Investment Income Tax on capital gains.

So while still taxable, long-term gains benefit from much lower rates than ordinary income. Holding assets long-term produces substantial tax savings versus short-term treatment.

Do I Need to Report Small Capital Gains?

You are only required to report capital gains (or losses) on your tax return if:

Your total capital gains for the year exceed your total capital losses for the year

You have any taxable income

So if your net capital gains and losses equal out to zero for the year, and you have no other taxable income, no reporting is required.

If you have taxable income, all capital transactions must be reported even if they net to zero. Or if you have leftover capital gains after netting, those must be reported.

But if only capital losses occurred, and losses did not exceed $3,000 deduction limits, no reporting is mandated. Just keep good records if losses carry over.

What is Considered Long-Term Investment Property?

Investments like stocks, bonds, mutual funds, and ETFs are considered “capital assets” subject to capital gains taxes if held for over one year.

Other common long-term capital gain assets include:

A home or other real estate held for personal use or as an investment
Cars, boats, and other tangible personal property
Art, collectibles, antiques, and memorabilia
Patents, copyrights, and other intangible intellectual property
Precious metals like gold and silver bars and coins
Business assets like equipment or property
Oil, gas, water, or mineral rights producing royalties

Appreciation on any tangible or intangible asset you sell for more than acquired for would produce a taxable capital gain.

Do I Pay Capital Gains Tax When I Sell My Home?

For a primary residence, capital gains tax exclusion rules allow you to shield tax on up to $250,000 in profit as a single filer or $500,000 if married filing jointly. To qualify for the home sale exclusion:

You must have owned and lived in the home as your primary residence for 2 out of the last 5 years before selling.
You can only claim the exclusion once every two years.
The exclusion can only be used on the primary residence, not second homes or rental properties.

As long as you pass the ownership, use, and frequency tests, the home sale capital gains tax exclusion allows shielding up to $500,000 in gain.

Capital Gains vs Dividend Income

Dividends and capital gains both produce investment income subject to preferential tax rates. However, key differences exist:

Capital Gains

Result from appreciation in the value of an asset you purchased
Realized as income when the asset is sold at a higher price than acquired for
Tax rate depends on your income and holding period

Dividends

Paid directly out of company profits to shareholders
Treated as ordinary investment income in the year paid
Qualified dividends taxed at capital gains rates

While similar preferential rates apply, capital gains arise from selling at a profit while dividends represent regular cash distributions that companies pay shareholders as income.

Frequently Asked Tax Questions

Below are some common capital gains and losses tax questions:

How are capital losses reported on tax return?

You list capital losses on IRS Form 8949. Total losses carry to Schedule D, where any excess over the $3,000 deduction limit carries forward.

What happens if I have a net capital loss?

You can deduct up to $3,000 against regular income. Remaining unused losses carry forward indefinitely.

Do I have to report small capital gains?

Only if total capital gains exceed total losses or you have other taxable income for the year.

Are collectible capital gains taxed at different rates?

Yes, collectibles like art and antiques are taxed at 28% rather than the typical 15%-20% rates.

Can capital losses offset ordinary income?

Yes, up to $3,000 in net capital losses can be deducted against ordinary income. Remaining excess carries over.

Are gifts or inheritances considered capital gains?

No, the cost basis is simply transferred. Capital gains taxes only apply if the recipient later sells at a higher price.

The Bottom Line

Tracking capital gains and losses on your investments takes diligence, but wise tax planning rewards the effort. While short-term trades trigger ordinary income rates, tax-deferred compounding paired with preferential long-term capital gains rates provides a twofold benefit for patient investors. Record keeping allows fully utilizing any realized losses to offset recognized gains and other income. Ultimately, sound capital gains and loss planning can control tax liability, boost after-tax returns, and reward your asset growth.