If you’re like many people, you know that you’ll have to pay capital gains taxes when you sell an investment property that has appreciated greatly in value since you bought it. (Unless, of course, you do a 1031 exchange – but that’s another topic for another day!) But how do you calculate capital gains taxes so you know whether you’re making the right decision for your investment portfolio? This guide explains.
How to Calculate Capital Gains Taxes
First things first: The Internal Revenue Service requires you to pay taxes on your capital gains. But for most people, the tax rate on most net capital gain is no higher than 15 percent. If your taxable income exceeds the thresholds set for the 15 percent capital gain rate, you could have to pay 20 percent. The big question for most people is how to calculate how much you’d have to pay if you sold your investment property.
In order to figure out how much you have to pay, you need to know the difference between short-term and long-term capital gains tax:
- Short-term capital gains tax is a tax on your profits from selling an asset that you held for a year or less. The short-term capital gains tax rate is the same as your ordinary income tax rate (that’s the tax bracket you fall into).
- Long-term capital gains tax is the tax on your profits from selling an asset that you held for more than one year. You could be subject to the 0 percent, 15 percent or 20 percent tax.
The money you make on the sale is what’s taxed – that’s your capital gain. If you made $10,000 in profits, that’s what you’re taxed on; you’re not taxed on the property’s full value.
You can use investment capital losses to offset your gains. The difference between your gains and losses is called your net capital gain. If your losses exceed your gains, you can even deduct the difference on your tax return (though you should consult with a tax professional before you do anything).
Example of How to Calculate Capital Gains Taxes
First, you need to know your property’s net purchase price, how much it’s depreciated or appreciated, and how much you’ve spent in capital improvements. Let’s say you purchased a property for $500,000 and it depreciated by $100,000. You made $25,000 in capital improvements. Deduct the $100,000 in depreciation and add the capital improvements amount for a total of $425,000. That’s your adjusted basis.
If you sell the property for $1,000,000, subtract the adjusted basis from that total. Your gain is then $575,000.
Using that number, apply the right tax rates. For example, the federal capital gain tax in this instance is 20 percent. You’d pay $115,000 in federal capital gains taxes on this sale. You may also be required to pay Medicare tax, California state tax, and a depreciation recapture tax.
Your best bet is always to work with a financial professional to calculate your capital gains taxes before you sell a property. That way, you’ll know exactly how much you’ll be expected to pay – and you can decide whether you want to defer your taxes through a 1031 exchange.
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