As a savvy investor, understanding the tax implications of your investment and implementing the appropriate tax strategy is vital for protecting your wealth. And this is especially the case if you are an investor looking to claim tax exemptions on capital gains.
While there is no debate over the fact that you must fulfill certain tax obligations to remain in the good books of the IRS, you can still claim tax exemptions to minimize your tax liability. This blog post will delve into these tax exemptions and answer some of your burning capital-gains-related questions, guiding you through the path to maximum returns on your investment.
What are Capital Gains?
Before we delve into exemptions, it’s essential to understand what capital gains are. Put simply, you make capital gains when you sell a capital asset like a real estate property or stock for a higher price than the purchase price. In other words, your capital gain is the difference between both prices, the purchase price (also known as ‘basis’) and the sale price.
For instance, consider you invested $184,000 in acquiring a building two years ago, and today, you’ve managed to sell that property for $245,000. Your resulting capital gains would be the selling price of $245,000 minus your initial purchase cost of $184,000.
Types of Capital Gains
There are two types of capital gains, as identified by the U.S. tax code. They are short-term capital gains and long-term capital gains. Below are the key differences.
- Short-term capital gains: Selling a capital asset you have owned for a year or less results in a short-term capital gain. Typically, this type of capital gain attracts heftier tax bills, as it is not eligible for special tax rates.
- Long-term capital gains: Long-term capital gains emerge from the sale of capital assets that you have had for more than one year. This type of capital gain will almost always get you lower tax rates than short-term capital gains.
Are Capital Gains Included in Your Income Tax?
Yes, your income tax will generally include your capital gains. However, capital gains are taxed at a different rate than your ordinary income.
Are You Required to Pay State Taxes on Capital Gains?
Most states in the U.S. will require you to pay a state tax on capital gains as part of your regular state income. Keep in mind that the exact rates are different across states, and the most ideal way to ensure compliance while optimizing your tax strategy for minimum tax payments is to hire the services of a tax consultant.
Here’s How You Claim Tax Exemptions on Capital Gains
- Use the Primary Residence Exclusion
The primary residence exclusion, also known as the home sale gain exclusion, is a powerful tax tool that you can use to claim tax exemptions on your capital gains. It’s outlined in Section 121 of the Internal Revenue Code, and it allows you to exclude a portion of the capital gains from the sale of your primary residence from your taxable income.
The exclusion limit is $250,000 if you are filing as a single taxpayer, but you can claim up to $500,000 if you are married and file jointly with your partner.
- Reinvest in Opportunity Zones
Investing in designated Opportunity Zones can also provide capital gains tax benefits. This strategy is like turning your investments into a superhero for economically distressed communities. New investments in such communities may be eligible for preferential tax treatment. When you reinvest unrealized capital gains into Opportunity Funds (dedicated to investing in these zones), you can defer and potentially reduce your tax on the reinvested gains.
- Consider the 1031 Exchange
Think of this strategy like a Pokemon card swap, but instead of trading Charizard for Pikachu, you’re swapping one investment property for another. Named after Section 1031 of the Internal Revenue Code, this provision allows investors to defer paying capital gains taxes when they sell an investment property and reinvest the proceeds in a “like-kind” property. This can be a great way to build wealth over time by moving up in property value without taking a tax hit.
- Leverage Tax-Loss Harvesting
Even a bummer scenario, like when one of your investments takes a nosedive, can be leveraged to your advantage. This is where tax-loss harvesting comes in. By selling investments that have gone down in value, you can offset capital gains you’ve made on other investments. It’s akin to making lemonade out of lemons, or more aptly, transforming investment losses into a tax-saving win!
- Always Consult with a Tax Strategist
When it comes to taxes and claiming tax benefits (in this case, tax exemptions), there is so much to keep tabs on. On top of that, there will always be a limit to how far you can go or achieve on your own. So, if you really want to protect the returns on your investment, minimize your tax burden, and not fall into the IRS radar for non-compliance, your best bet is to consult a professional tax strategist.
Pro tip: Parting Advice
When choosing a tax strategist to work on your tax strategy, look out for one with a track record of excellent results. They also need to be willing to put the necessary resources and effort into assessing your unique situation to devise a tax strategy that works best for your goals.
Wondering where to find tax strategists that check these boxes and more? Look no further than Tax Goddess. You can find out more about how the world-class tax strategists at Tax Goddess can help you claim substantial tax exemptions by BOOKING YOUR FREE CONSULTATION today!
Catch you in the next post!