Capital Gains Reporting on a 1040 Tax Return

Simon Misiewicz

Expat & Property Tax Specialist

9th March 2022

What is capital gains tax in the United States?

Capital gains tax in the United States payable to The IRS is a tax applied to the profits made from the sale of an asset.

Capital gains tax is only payable once the asset has been sold. The capital gains tax paid depends on different factors, including income level, marital status, income tax bracket and cost basis of the asset.

It is a tax on the increased value of investments realised when individuals or corporations sell them.

Capital gains tax does not apply to an unsold investment.

Stock shares that appreciate annually would not incur capital gains tax until sold.

The IRS classifies capital gains as profits from the sale of an asset.

The asset could be shares of stock, a piece of land, or a business classified as taxable income.

The amount of capital gains tax paid varies depending on how long the investment has been held.

Short-term capital gains and long-term capital gains are taxed at different rates.

The amount of capital gains tax paid to the IRS depends on three main factors: the size of the gain, your income tax bracket, and how long you have held the asset.

Some industry commentators claim that capital gains taxes are paid disproportionately by high-income US households as they are more likely to possess assets that generate taxable gains.

It has also been argued that those who pay capital gains tax in the US have more ability to pay.

This also means that these high-income investors can more easily defer or avoid capital gains tax payment as it only becomes due if and when the owner sells the asset.

Taxable capital gains can also be reduced by the number of capital losses incurred over the same period.

A capital loss occurs when an owner sells an investment for less than purchased.

The total of long-term capital gains minus any capital losses is called the ‘net capital gain’, the amount capital gains taxes are assessed on.

Capital gains tax only applies to capital assets, including stocks, bonds, jewellery, coin collections and real estate property.

Taxpayers can use different strategies to offset capital gains with capital losses to lower their capital gains tax liability. This article will highlight these strategies further.

The IRS has clear guidelines on capital gains tax which are worth reviewing. Capital Gains Reporting on a 1040 Tax Return is required by those that sell a US real estate property. Americans must also report a capital gain on foreign real estate property on a 1040 tax return. 

What is the difference between short-term and long-term Capital Gains Tax?

Short-term capital gains tax is a tax on profits from the sale of an asset held for one year or less.

The short-term capital gains tax rate equals an individual’s income tax bracket.

Long-term capital gains tax is a tax on profits from selling an asset held for over a year.

The long-term capital gains tax rate is 0%, 15% or 20%, depending on your taxable income and are generally lower than short-term capital gains tax rates.

Your tax rate for long-term capital gains could be 0%, depending on your regular income tax bracket.

Taxpayers in the highest income tax bracket pay long-term capital gains rates up to 50% lower than their income tax rates charged on their ordinary income.

How does The IRS calculate capital gains in the United States?

Capital losses can be deducted from capital gains to reduce taxable gains for the year.

The calculations can be complex if you’ve incurred capital gains and capital losses on both short-term and long-term investments during the same period.

Short-term gains are netted against short-term losses to produce a net short-term gain or loss.

The same is done with long-term gains and losses.

These numbers for the short-term and long-term are reconciled to produce a final net capital gain or loss filed on the tax return.

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What are the exceptions? Capital Gains Reporting on a 1040 Tax Return

Some types of assets get different capital gains tax treatment. These include:

– Collectables – gains on collectables such as art, antiques, jewellery, precious metals, coins, and stamp collections are taxed at 28% by the IRS regardless of your income.

– Owner-occupied real estate – real estate capital gains are taxed differently if you’re selling your primary residence.

$250,000 of an individual’s capital gains in a home may be excluded if they lived in it for two years. This exclusion is $500,000 for those married and filing jointly.

Capital losses from the sale of personal property such as a home are not deductible from gains.

Investors who own real estate can take depreciation deductions against income to reflect the deterioration of a property as it ages. This is a great way to reduce your annual property taxes incurred on your rental income.

Any depreciation deduction essentially reduces the amount the investor is considered to have paid for that property originally.

That can increase the taxable capital gain when the property is sold.

The gap between the property’s value after deductions and the sale price will be more significant.

Non-resident aliens are also exempt from capital gains tax in the US.

This is a significant exemption and is worth bearing in mind when investing.

Make sure you research how the IRS taxes non-resident aliens

How is Net Income Investment Tax (NIIT) relevant to capital gains?

If your income in the United States is high, you may become subject to Net Income Investment Tax (NIIT).

If your modified adjusted gross income exceeds certain levels, this additional tax imposes an extra 3.8% on investment income, including capital gains.

Those levels are $250,000 if married and filing jointly. This is reduced to $200,000 if single or the head of a household. It is also further reduced to $125,000 if married and filing separately.

Can I avoid US Capital Gains Tax by buying another house?

You must meet the residency rule to qualify for the exemption if you purchase a second home and start using it as a primary residence. Namely, you would have needed to have owned the property for two years.

There is also the two out of five-year rule, which means that you can live in a house for a year, rent it out for three years, and then move back into it for 12 months.

The IRS will then concur that the home qualifies as your principal residence.

There is also the opportunity of investing the money you have obtained into another real estate investment. There is the ability to use a 1031 exchange. This process allows you to reinvest the funds received from the property and reinvest it. The capital gains are then rolled over until you sell the newly purchased property.

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What is tax-loss harvesting?

Tax-loss harvesting involves selling an investment that yields a loss, replacing it with a similar investment, and then using the investment sold at a loss to offset any gains.

Tax-loss harvesting is a smart way to avoid paying capital gains tax.

The money lost on investment can offset capital gains on other investments.

Investors can write off losses when selling a depreciated asset, cancelling some or all of the capital gains made on appreciated assets.

This strategy can help reduce the amount of capital gains tax paid, although it is focused on a short-term tax break rather than on long-term considerations as an investment strategy.

Can I minimise capital gains tax?

Before selling them, you can minimize capital gains tax by holding assets and investments for more than a year. Did you know that you do not pay Capital Gains Tax if you refinance your real estate property? This might be a better way to pull money out of your investment rather than paying Capital Gains Tax.

The tax on long-term capital gains is generally lower than for short-term gains. Significant tax savings can be made on capital gains by holding an asset or investment for 12 months or longer.

An investor could also utilize losses incurred on previous investments to offset their tax bill in the current year.

If the primary residence has been owned for at least two years in the five years before it is sold, then capital gains of up to $250,000 can be excluded from a home sale if you are single. This rate increases to $500,000 if married and filing jointly.

Avoid property tax using tax-efficient investment structures

Investing in tax-advantaged accounts such as 401(k) plans, individual retirement accounts and 529 college savings accounts allows investments to grow tax-free or tax-deferred.

You do not have to pay capital gains tax if selling investments within these accounts.

Roth IRAs and 529s provide significant tax advantages because you do not pay any tax on investment earnings.

It is also worth considering waiting until retirement to sell profitable assets.

The capital gains tax bill could be reduced if your retirement income is low enough.

It could even mean you avoid paying any capital gains tax.

Remember that an asset or investment must be sold after a year’s holding for the sale to qualify for treatment as a long-term capital gain.

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