The capital gains tax regime has been one of the key factors for the growth of the U.S. economy. By providing investors with the ability to benefit from a lower tax rate for holding an investment greater than a year, the capital gains tax has functioned to encourage savings and increase economic growth. The capital gains tax regime only applies to capital assets.
This article will describe, in simple terms, how the capital gains tax regime works, as well as explain how using a Self-Directed IRA or Roth IRA can prove even more tax advantageous.
- Most holdings, such as stocks and real estate, are considered capital assets
- Capital assets are subject to either short- or long-tern capital gains tax
- Using a Self-Directed IRA to invest shelters you from the tax as long as the asset remains in the plan
What is a Capital Asset?
According to the IRS, almost everything you own and use for personal, or investment purposes is a capital asset. Examples include a home, car, and stocks or bonds held as investments. A capital asset is property that is expected to generate value over a long period of time. In essence, from a tax perspective, a capital asset is all property held by a taxpayer, with the exceptions of inventory and accounts receivable.
Taxation of Capital Gains
Federal tax law apportions capital gains into two different classes determined by the calendar.
Short-term gains come from the sale of property owned one year or less; long-term gains come from the sale of property held more than one year. Short-term gains are taxed at your maximum ordinary income tax rate, where the maximum tax rate in 2023 is 37%. Whereas, most long-term gains are taxed at either 0%, 15%, or 20%. For most people, you will be in the 15% bracket if your income falls between roughly $42,000 and $460,000.
In order to determine whether your capital gains transaction will be subject to the short-term or long-term capital gains tax rules depends on the period of time the taxpayer held the asset. When figuring the holding period, the day you bought the asset does not count, but the day you sold it does. So, if you bought a capital asset, such as a piece of real estate, on April 20, 2022, your holding period began on April 21, 2021. April 20, 2023, would mark one year of ownership for tax purposes. If you sold the asset on that day, you would have a short-term gain or loss. A sale of the asset one day later, on April 21, would produce long-term tax consequences, since you would have held the asset for more than one year. The federal income tax rate you pay depends on whether your gain is short-term or long-term.
Related: Self-Directed IRA Real Estate vs. Capital Gains
A capital loss is a loss on the sale of a capital asset such as a stock. As with capital gains, capital losses are divided by the calendar year into short- and long-term losses and can be deducted against capital gains, but there are limitations. Losses on a capital investment is first used to offset capital gains of the same type. Hence, short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain.
So, for example, if you have $4,000 of short-term loss from a stock investment and only $1,000 of short-term gain from a stock investment, the net $3,000 short-term loss can be deducted against your net long-term gain (assuming you have one).
If a taxpayer engages in numerous capital asset transactions in a particular year, the end result could be a mix of long- and short-term capital gains and losses If you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other kinds of income, including your salary and interest income, for example. Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income. If you use married filing separate filing status, however, the annual net capital loss deduction limit is only $1,500.
When Do you Owe Capital Gains Tax?
The federal income tax rules do not tax all capital gains. Rather, gains are taxed in the year an asset is sold, regardless of when the gains accrued. Unrealized, accrued capital gains are generally not considered taxable income. For example, if you bought a capital asset for $10,000 five years ago, and it’s worth $30,000 now and you sell it, your taxable capital gain would be $20,000 in the current year, and zero in the previous years.
Capital Gains and Mutual Funds
A mutual fund is a professionally managed investment fund that groups money from many investors to purchase securities. Based on the mutual fund rules, mutual funds that accumulate realized capital gains throughout the tax year must distribute them to shareholders.
Many mutual funds distribute capital gains right before the end of the calendar year, even if they are short-term capital gains. For tax conscious investors, owning a mutual fund in an IRA or 401(k) plan would prove more tax advantageous because a retirement account does generally not pay any tax on income or gains generated on a capital asset investment.
The Self-Directed IRA & Capital Gains
One of the primary tax advantages of using a Self-Directed IRA to make investments is that, in general, all income and gains are tax-deferred or tax-free in the case of a Roth IRA. In other words, an IRA would not be subject to ordinary income tax or any capital gains tax on income or gains allocated to an IRA, irrespective of holding period.
For active stock or crypto traders, using a Self-Directed IRA is a huge tax advantage. Most active traders will not hold the underlying asset for longer than twelve months, meaning the gains from the capital investment would be subject to short-term capital gains, which is taxed based on the taxpayer’s ordinary income tax rate. Whereas, if the investor used an IRA to make the investments, no tax would be due on any of the trading gains, The same principles would apply if the IRA invested in real estate.
The one drawback for using a Self-Directed IRA versus personal funds to make a capital investment, such as real estate, is that by using personal funds one can benefit from depreciation and other deductions, as well as pass-through tax losses. Although, depreciation recapture could be owed on a sale.
In addition, the sale of the asset would be subject to capital gains. Versus, owning the real estate in an IRA, where the IRA would not benefit from any losses, and IRA distributions are subject to ordinary income tax. Though, an IRA would be able to take advantage of the power of tax deferral and defer all income and gains until a later time when a taxable distribution is taken. Of course, a Roth IRA would trump the pretax IRA option and likely also the personal fund option since all qualified Roth IRA distributions are tax-free.
Making an investment that generates long-term capital gains versus ordinary income is considered tax savvy. Using a Self-Directed IRA to make that same investment could be considered ingenious since you could potentially defer or eliminate any future tax on the asset.
Whichever way you decide to invest, you should know the ramifications of both types of capital gains, and you can potentially use losses to offset any taxes incurred.