Are Capital Assets Subject to Tax? Ultimate Guide

Capital assets are any significant investments held by an individual or a business. As long as these assets are held by the owners, they are not subject to any taxes.

Capital assets owe taxes with capital gains. The tax rates are significantly lower than ordinary income tax rates. However, taxpayers must be mindful of certain conditions to take full advantage of capital gains tax rates.

Let us discuss what are capital assets and how are they subject to taxes.

What is a Capital Asset?

For individuals, a capital asset is any significant piece of property such as a house, car, or business. It can also be in the form of an investment such as in an IRA, stocks, bonds, or even collectibles.

From a business perspective, a capital asset is any asset held by a business for more than one year. These are also called long-term or fixed assets. Capital assets of a business held for more than one year should not be held for sale.

Generally, we can define a capital asset as an asset held by an individual or a business. However, some individuals or businesses may hold significant properties and other assets for business transactions.

For example, an individual trader may hold significant stock investments. If these stocks are traded frequently, they should not be treated as capital assets regardless of their net value.

Similarly, if a business holds significant property or assets for business transactions, they cannot be classified as capital assets. For instance, property held by a real estate business does not qualify as a capital asset.

Taxes on Capital Assets

Capital assets are not subject to taxes on their values. As long as the owner holds the ownership of capital assets, there are no taxes payable.

Capital assets also do not incur any tax obligation when they change market value. A common scenario can be observed when a real estate property increases or decreases its market value. Similarly, stocks held by an investor keep changing their net value but do not incur a tax obligation.

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Capital assets are subject to taxes with capital gains only. It means if the owners of capital assets make gains on the sale of these assets, they are liable for capital gains taxes.

Generally, we can categorize capital gains taxes into two types.

Short-Term Capital Gains Taxes

Short-term capital gains are applicable for gains made on the sale of capital assets before one year. These gains from the capital assets are applied as a normal income tax.

Practically, short-term capital gains incur higher tax rates. The rule is applied to discourage short-term trading strategies that make illegal profits. Thus, it makes sense to hold capital assets for more than one year whenever possible.

Long-Term Capital Gains Taxes

These taxes are applicable for gains made through sales of capital assets held for more than one year. Generally, the tax rates for long-term gains are lower than ordinary income tax rates.

For example, in the US there are three tax slabs for the long-term capital gains taxes; 0%, 15%, and 20%.

Special Considerations with Capital Gains Taxes

Capital assets provide tax benefits to taxpayers in several ways. The prime benefit is the lower tax rate when capital assets are held for more than one year.

The ownership, value of the asset, time held as owner, and other factors play a key part in determining the total tax obligation for a taxpayer.

Here are a few special considerations with capital gains taxes for you.

Your Home or Residence Place is Exempted

Unlike the common notion, the real estate property used for a primary residence is exempted from capital gains taxes. Taxpayers must fulfill certain conditions such as a minimum residence tenure to be eligible for these exemptions.

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It gives taxpayers significant tax relief. For instance, the IRS allows up to $ 250,000 for an individual and $ 500,000 for joint filers to exclude from the sale of primary residence or home of the taxpayers.

Collectibles as Capital Assets

Collectibles held as capital assets are treated differently. Collectibles may include art, paintings, antiques, jewelry, or precious metals.

The capital gains tax rate for collectibles is 28% set by the IRS. It means if you are in a lower tax bracket, you’ll incur a higher tax bill and vice versa.

Depreciation Rules for Real Estate Assets

Taxpayers can deduct depreciation expenses for real estate properties and other fixed assets. The depreciation expense reduces the total tax liability of the taxpayer until the capital asset is sold.

The accumulated depreciation is then charged for tax purposes on recapturing basis. The remaining amount of the sale proceeds is then taxed at capital gains tax rates.

Capital Assets as a Business

Many businesses are involved in buying and selling significant or capital assets. Common examples include real estate, antiques, jewelry, automobile showrooms, and so on.

The income from these business transactions is treated as business income rather than capital gains. The tax credits, deductions, and exemptions rules for business income are applicable for these transactions.

Strategies to Reduce Your Tax Bill on Capital Assets

Capital assets are useful investments for taxpayers to reduce their tax bills. Capital gains on assets held for more than one year are generally lower than ordinary income taxes.

Taxpayers can follow some useful strategies to further reduce or eliminate their capital gains taxes as well.

Consider the Holding Period

Consider the difference between short-term and long-term capital gains. The difference can be anywhere between 10-20% for you.

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If you are planning to sell a capital asset, recheck the purchase date. It is always advised to hold the capital asset for at least one year.

Offset Gains with Capital Losses

You may incur capital losses as well instead of gains. Some of your capital assets may incur capital losses that you can use to offset other gains.

When your total capital losses exceed capital gains, you can carry over the losses for the next tax period as well. Else, you can offset these losses against your ordinary income tax up to certain limits.

Exclude Home Sales

You can exclude your home sale from capital gains taxes. It can significantly reduce your capital gains taxes particularly at the time of retirement.

You’ll need to qualify for these exemptions if you used a house as your primary residence for more than two years in the last five-year period.

Use Tax-Advantaged Accounts

Your money goes tax-free in several retirement plan accounts. These accounts include 401(k), Roth IRA, and traditional IRAs.

Unless you withdraw money from these accounts, you do not incur any capital gains taxes. If you withdraw money from these accounts after retirement, you’ll pay lower taxes than other capital gains.

Be Mindful of Wash-Sale Rules

Many traders make the mistake of selling stocks that are making losses to buy them again. If you make the sale and buy transactions within one month, you may incur an IRS penalty.

The wash-sale rule is made to avoid such illegal practices of traders that can evade taxes. Be mindful of the wash-sale rule so that you don’t have to pay any penalty over your tax bill as well.