Capital gains refer to profits generated from the sale of capital assets of a higher value than what was paid for. Capital assets comprise investment products, such as stocks, bonds, mutual funds or other real estate products like land, houses, just to name a few.
Capital gains can be short-term or long-term. Short-term capital gains are profits gained from the sale of assets held for less than one year while long-term capital gains are profits accrued from the sale of assets held for more than one year.
The calculation for both types of capital gains are as follows:
Short-term capital gain = final sale price - (the cost of acquisition + improvement cost + transfer cost)
Long-term capital gain = final sale price - (transfer cost + indexed acquisition cost + indexed improvement cost)
Indexed acquisition cost = cost of acquisition x cost inflation index of the year of transfer/cost inflation index of the year of acquisition.
Indexed improvement cost = cost of improvement x cost inflation index of the year of transfer/cost inflation index of the year of improvement.
How capital gains tax is calculated
Each type of capital gain is subject to a different tax system.
Tax levied on short-term capital gains is known as short-term capital gain tax. These gains are taxed as though they were ordinary income. The short-term capital gains will be added to the total income of an investor and the tax payable is calculated based on the tax bracket that the total chargeable income falls under for income tax. The short-term capital gains may be taxed at a higher rate than regular earnings if the addition of capital gains resulted in the total chargeable income moving to a higher tax bracket.
On the other hand, a tax levied on long-term capital gains is known as long-term capital gain tax, which takes into consideration inflation. The rates these capital gains are charged depends on the rate schedule, which varies according to income thresholds.
Not all states have income taxes imposed on an individual’s income. This also means that not every state will tax an investor’s capital gains. Examples of states that have no income taxes include, but are not limited to, the following - Alaska, Florida, New Hampshire, South Dakota, Texas, and Washington, among others.
Capital gains tax in real estate investment
Investors who own real estate are often allowed to deduct the depreciation cost incurred on their property from the income to show the deterioration of the property as it ages. When depreciation is removed, it reduces the principal amount paid for the property, raising the taxable capital gains when the investor sells the property due to the widening gap between the property’s value after deductions and the selling price of the property.
Assuming that an investor paid $200,000 for a property, and is allowed to make a $10,000 claim for the depreciation of the property. In this case, the investor will be considered to have paid $190,000 for the property. When the property is sold, the $10,000 is then treated as depreciation deductions recouped. When the investor sold off the property at $220,000, the capital gains from the sale would be $30,000 (i.e., $220,000 - $190,000). Then, $10,000 of this amount would be recaptured from income as a deduction from sales. If a 30% tax rate is applied on the recouped depreciation amount, the $10,000 will be taxed at 30%, and the remaining capital gains of $20,000 (i.e. $30,000 - $10,000) will then be taxed according to the income level of the investor.
How to minimise capital gains tax on real estate property?
In countries like the U.S., one can avoid paying capital gains tax on the sale of real estate property through the 1031 exchange. By using the 1031 exchange, real estate investors can defer taxes while building wealth. The 1031 exchange, also known as Section 1031 of the United States Internal Revenue Code, allows a taxpayer to defer the capital gains and depreciation recapture taxes from the sale of an investment property with the purchase of other like-kind real estate properties within 180 days. The 1031 exchange is only applicable to business and investment properties.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.