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How Capital Gains Taxes Work

When you hear about billionaire Warren Buffett paying a lower effective tax rate [3] 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 [4]. 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 [5] 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 [6])