How Capital Gains Taxes Work

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Wall StreetWhen you hear about billionaire Warren Buffett paying a lower effective tax rate than his secretary, you’re hearing long term capital gains at work. The tax code smiles favorably on investment and the tax rate on capital gains of assets held for more than one year is much lower than ordinary income tax rates. If you own an asset for less than one year, you pay short term capital gains which mirror the rate of ordinary income tax.

Qualified dividends also enjoy favorable tax rates, with the income taxed at long term capital gains, which make them especially appealing to those on fixed income, such as retirees. As long as the dividend is considered a qualified dividend, you can enjoy the lower rates.

So what are the capital gains tax rates for 2012?

Capital Gains Tax Rates

The capital gains rate you pay will depend on your ordinary income tax rate.

Tax Bracket Short Term Rate Long Term Rate
10% Bracket 10% 0%
15% Bracket 15% 0%
25% Bracket 25% 15%
28% Bracket 28% 15%
33% Bracket 33% 15%
35% Bracket 35% 15%

Unless something changes, capital gains rates are set to increase, along with ordinary income tax rates, after this year. Long term capital gains rates would increase to 10% for those in the 15% bracket and 20% for those taxpayers in higher brackets.

Primary Home Exclusion

There is one huge exception to the capital gains rule and it’s for your primary residence. If you sell your primary residence, defined as a place you lived in for two of the last five years, then you can exclude $250,000 of capital gains from your tax return. You simply don’t report it on your return and so you pay no tax. If you are married, the exclusion increases to $500,000 ($250k a piece). This can be a huge tax break depending on how much you gained on the sale of your home and makes owning a home so favorable (not including the mortgage interest rate tax deduction) compared to similar investments.

If you want to pay lower tax rates, then you need more capital gains. Easier said than done, huh? 🙂

(Photo: epicharmus)

{ 7 comments, please add your thoughts now! }

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7 Responses to “How Capital Gains Taxes Work”

  1. Scott says:

    Jim – Does the primary home exclusion have any expiration date or is that good for the foreseeable future?

  2. Jim says:

    Theres no expiration on that, as far as I know. It’s kind of shady too, you just don’t report it on your return.

    • Jerry C says:

      There are many items of income that are “excludable” income. Many people receive mass transits vouchers from their employers which are totally tax free. Many forms of income related to owning a home is excludable because the USA encourages home ownership. There is nothing shady about that. I think most Americans would agree that encouraging homeownership is a worthy goal of federal income tax policy. Now, the whole thing about tax deductions for kids, I’m totally against. I don’t like kids :), those little loudmouth rugrats.

  3. I doubt long-term capital gains taxes will increase anytime soon. I can already hear the political rhetoric around the necessity of keeping these rates at a max of 15%. Even if the country can’t afford it and 20% still ain’t bad.

  4. Dividends are awesome for those looking for fixed income, but I wonder if long term capital gains rate and the dividend tax rate will always be the same?

  5. Jerry C says:

    Thank you for the informative article about capital gains taxes. The last piece of advice to increase you capital gains earnings is what rich people learn from the cradle. Every nation’s tax system encourages certain behavior and discourages certain behaviors. We discourage smoking by slapping large taxes on it. The US also discourages WORK by putting higher rates on earned income opposed to capital gains income. Rich people know this and spend their time investing as opposed to working. As a tax professional, I’m not saying this is right or not, but this is the system we live under and which we must make due under.

  6. Milt says:

    It seems as if no one ever mentions that most middle income tax payers do not use the mortage interest paid exception on their income tax returns due to standard deduction. This tax deduction is for the wealthy and not middle income.

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