Investors strive for capital gains, but they have a tax impact as well. In this article, we’ll explain capital gains, adjusted gross income (AGI), and whether capital gains play a role in calculating adjusted gross income.
What are Capital Gains?
Capital gains are the profits you make when selling or trading a capital asset. Generally, a capital asset is any investment like stocks, bonds, real estate, collectibles, and cryptocurrency. When you make money on an investment, which is a capital gain, you have to pay capital gains tax. However, there are some exceptions.
What is Adjusted Gross Income?
Adjusted gross income (AGI) is your gross income minus adjustments. The IRS uses your AGI as the basis for calculating your taxable income, and AGI can determine the deductions and credits you qualify for.
Gross income includes:
- Wages
- Capital gains
- Business income
- Investments
- Social Security
- Pensions
- Real estate
- Unemployment
- Dividends
- Alimony
- Retirement distributions
Adjustments include:
- Contributions to retirement plans and health insurance for self-employed
- Deductible self-employment taxes
- Certain business expenses
- Deductible HSA contributions
- Deductible IRA contributions
- Student loan interest
- Educator expenses
- Moving expenses for military members
- Penalties for early retirement withdrawals
- Alimony paid
- Standard deduction for charitable contributions up to $600
Capital Gains and Adjusted Gross Income (AGI)
Capital gains can be taxed differently, but they are still included in your adjusted gross income. This can affect the tax bracket you are in and your ability to participate in income-based investments.
When You Owe Capital Gains
Typically, selling an investment has tax consequences. To determine if you need to report a gain, you need the cost basis of that investment. Capital gain (or loss) is the difference between the selling price and that basis.
In the case of stocks and bonds, the basis is typically the price at which you purchased them. This includes purchases made when dividends or capital gains distributions were reinvested. It also includes other costs like commission or other fees you paid to complete the transaction.
If you held the security for less than a year, then the gain is taxed as ordinary income If it’s been more than one year, the gain is considered a long-term capital gain and taxed at a lower rate.
For homeowners who have owned and lived in a home for at least two out of the five years before the sale, up to $250,000 ($500,000 for those filing jointly) of the gain is not taxed. Gains above the $250,000 or $500,000 exclusion are taxed at capital gains rates.
To calculate the tax basis for the home, start with the purchase price, and add certain closing costs and settlement fees. In addition, add the cost of any additions and improvements. Repairs and maintenance don’t increase your tax basis.
Gains from selling a vacation home don’t qualify for the $250,000/$500,000 capital gains tax exclusion for primary homes. When a vacation home is sold, the gain is subject to normal capital gains tax rules.
When selling a rental property, there are two types of capital gains: short and long-term. Short-term investments are properties held for a year or less, and capital gains are treated as regular income and taxed based on your federal income tax rate. Long-term gains refer to property held for a year or more, and capital gains rates depend on your taxable income.
1031 Exchanges and Capital Gains
Real estate investors can postpone capital gains taxes by selling a property and using the proceeds to buy a like-kind property. You’ve not received proceeds from the sale, so there aren’t any capital gains to tax. This is a 1031 exchange, and it works as follows:
- Identify a property you want to buy. It must be similar to or higher in value than the property you are planning to sell.
- Choose a qualified intermediary who will hold your funds in escrow until the exchange is complete.
- Relinquish the property.
- Purchase a replacement property.
- Notify the IRS of the transaction via Form 8824 on your tax return.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
