The primary goal of making investments is to earn a profit at some point. When it comes time to sell real estate, stocks or bonds, you know that the IRS will want its share of those profits. This profit is referred to by the IRS as your “capital gains,” and the tax the IRS will impose those capital gains can be significant. But, if you have some basic knowledge about how capital gains work and some of the ways you can lower the potential capital gains tax, it is quite possible you could save some of your investment by reducing the capital gains tax. Let our Roseville estate planning attorney help with your plan.
When is the capital gains tax assessed?
In general terms, you earn a profit when the sales price of the property you are selling is higher than the price for which the property was initially purchased. For example, if you purchased diamond earrings for your wife for $200.00 and she later sells those earrings for $350.00, then the capital gain would be $150.00 for many people. You are required to report that profit or income to the IRS as a capital gain and a tax would be assessed.
The amount of the tax depends on the amount of the profit. It is important to remember that you can only be taxed on a capital gain that has been “realized.” That means the property was actually sold. In other words, simply because the value of the diamond earrings you bought for your wife may have increased, there is no capital gain until you sell them.
Which assets are subject to the capital gains tax?
The capital gains tax is only imposed on the sale of a “capital” asset, which defined rather broadly by the IRS. Ultimately, most of the property you own or use for personal or investment purposes is considered a capital asset. However, it is not very common for people to sell the majority of their property or assets for profit. The most common capital assets are usually securities, real estate, and valuable collectibles. So, if you sell a capital asset and make a profit from that sale, then it will qualify as a capital gain and be taxed accordingly.
How to lower your capital gains tax
One concern many investors have is whether it is better to make short-term investments at higher interest rates. However, once the capital gains tax is imposed, you are likely to earn much less profit than you might have expected. Actually, avoiding short-term investments can save on capital gains taxes. With a long-term investment, which typically has a much lower tax rate, you may pay no taxes on your capital gains, depending on your tax bracket.
What is a “Step up in Basis?”
Capital gains taxes are handled a bit differently when you are dealing with inherited property. There is an important tax break, the “step up in basis,” which can save a substantial amount of taxes, simply by adjusting the value of your inheritance. Here is how it works. Your grandmother purchased a home 20 years ago for $60,000.
If you inherit the home and sell it now for $200,000, your capital gain would be $140,000. But, the house is actually valued now at $150,000, instead of the $60,000 she paid for it 20 years ago. Based on the step up in basis rule, your capital gain would be based on the current value of the home. That means, instead of a capital gain of $140,000, it would only be $50,000. That is a huge saving.
Preserving eligibility for the step up in basis
Unfortunately, there are some decisions you could make that would likely result in losing this tax saving opportunity. The most common mistake is having joint ownership of your home, either with your child or your spouse. Joint ownership with your child would prevent her from benefiting from the step up in basis rule because the original purchase price will be your child’s basis, since she is also an owner.
If you want your child to inherit your home, then you should consider transferring your home to a living trust, with your child as the beneficiary. The same is true if you hold the title of your home in joint tenancy with your spouse. The surviving spouse will be required to pay capital gains tax based on the original cost of the home. If you have questions about exactly how this works, let our Roseville estate planning attorney explain.
Download our FREE estate planning checklist today! If you have questions regarding estate planning matters, please contact us at the Northern California Center for Estate Planning and Elder Law for a consultation. You can contact us either online or by calling us at (916) 437-3500. We are here to help!