Paying taxes is an unfortunate requirement, and you may pay a wide range of taxes each year. Taxes may be used to pay for the schools, military, law enforcement, fire control services and more. These taxes include everything from property and income tax to your car registration, sales tax and more. Many people have heard about capital gains tax, but you may not be familiar with what this is or about the effective strategies to avoid paying it. When you learn more about the tax, you can also learn how to avoid capital gains tax to save money.
Understanding Capital Gains Tax
Anytime you sell real estate or another type of investment, such as stocks, you will have either a profit or a loss. The profit is known as a capital gain, and you are required to pay a capital gains tax on any real estate or investment profits you generate for the year. This can play a direct role in boosting your income level into a new tax bracket, and the result is a very high tax bill for some individuals.
Learning how to avoid capital gains tax can save you thousands of dollars or more in many cases, and there are several great strategies that you can consider using.
Limits and Amounts
Before you learn how to avoid capital gains tax, it is important to determine the limits and amounts that you may be responsible for. Generally, you will be taxed at a rate based on your overall income bracket or tax rate. There is no maximum limit for this tax. Additionally, you could potentially pay almost 40 percent for this tax if you fall into the highest tax rate category. You may use an online capital gains tax calculator to estimate your tax liability for the upcoming year.
What Types of Capital Gains Tax Are There?
Capital gains can be classified in two different ways for taxation purposes. Short-term gains are generated from assets that you owned for less than 12 months. Long-term gains are generated from assets that you owned for a year or longer. The tax rate varies dramatically based on how long you owned the asset.
The rate for short-term gains ranges from 10 to 39.6 percent, and it is equivalent to your normal tax bracket. The rate for a long-term gain is substantially lower, and it ranges from zero to 20 percent. In some cases, simply holding onto the asset for a few more days or weeks can help you to cut your tax bill in half through the classification as a long-term gain.
Reporting and Paying the Capital Gains Tax
Capital gains, as well as losses, are reported on Schedule D of your 1040 tax return, and they should be reported in the tax year when they were realized. Before you fill out your Schedule D this year, however, you should learn how to avoid capital gains tax.
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How to Avoid Capital Gains Tax
There are several strategic methods that you can use to offset your capital gain. This can help you to decrease your tax liability for the upcoming tax year.
1. Cut Your Losses
Your total capital gains, as well as losses, for the year will be added together, and the net amount will be taxable. If you have a year with a significant capital gain, consider selling some of your underperforming assets for a loss.
These may be assets that potentially could never perform well for you, and selling them for a loss can help you to avoid a huge tax bill. Remember that you can always buy them again later at the same or even at a lower price.
2. Take Advantage of the Primary Residence Exclusion
You must report and pay tax on a capital gain on a personal residence, but you cannot show a loss on it. While this may seem unfair, the IRS allows homeowners to exclude up to $250,000 in capital gains on the sale of a primary residence for individuals and up to $500,000 for married couples.
There are specific rules that you need to meet, like length of time in the home, before you can qualify. When selling a primary residence, use this exclusion to avoid paying more than necessary in capital gains tax.
3. Use a Tax-Deferred Exchange
If you are looking at a potential capital gain from the sale of investment property, you can complete a tax-deferred, like-kind exchange. This is a special loophole that the IRS has established. It allows you to transfer any gain from the sale of rental property into the purchase of another rental property.
You must follow specific rules to qualify for this, such as identifying the property you plan to purchase within a specified number of days. A similar type of exchange is available for gains from stock investments.
4. Max Out Your Retirement Account Contributions
Your contributions for some types of retirement accounts can directly offset your tax liability by lowering your taxable income. You may be able to use these contributions to qualify for a lower tax rate. If you want to know how to avoid capital gains tax altogether, this will not eliminate the tax burden.
However, you may be able to save a substantial amount of money. You can do this by placing yourself in a lower tax bracket for both short-term and long-term capital gains.
5. Fund Your Health Savings Account
Your contributions to your health savings account can work in the same way as your retirement account contributions. These contributions can lower your taxable income and potentially launch you into a lower tax bracket. You should carefully analyze the tax brackets and consider making last-minute contributions to your health savings account for the year to take advantage of this option.
6. Renovate Your Home
When you renovate your primary residence, you can boost its value through strategic improvements. This can cause a hefty capital gain on the home. However, you can avoid that capital gains tax by using the primary residence exclusion. Keep in mind that this benefit only works on homes that you live in as a primary residence. It will not work on investment real estate.
7. Show Paper Losses on Rental Properties
Another option when you want to know how to avoid capital gains tax is using rental properties to show a paper loss. You may show a real return on positive cash flow. However, factors such as depreciation and operating expenses can result in a paper loss. You can strategically set up your real estate investments so that they generate a taxable loss for you.
The capital gains tax that you may be responsible for can be a staggering amount. It can also be burdensome to pay such a high tax amount. If you have capital gains this year, plan ahead by using one or several of these options. These are legitimate ways to avoid paying capital gains tax or to reduce the amount of tax you pay substantially. You may be able to use some of these ideas regularly to offset your general income tax each year as well.