Capital Gains & Taxes (5 minute read)
“Risk taking is the mother’s milk of capitalism.” –Wall Street Journal
Whenever a home, business, or any other asset increases in value over time, that increase is called a capital gain. Even though it is a form of income, it differs from wages and salaries because it isn’t paid right after the increase and usually only after an integral of some years.
A 10-year bond can only be cashed in after 10-years. If you never sell your home, then whatever gain in value that the home has, will be called an un-realized capital gain. The same is true for someone who owns a business with increasing value. As the business grows, the underlying value should increase. Once the owner dies, the spouse or family members my chose to sell the business which then induces a capital gain that is realized at the time of sale.
Sometimes a capital gain comes from a transaction. Paying someone money today to get a return later on is an example. A savings account that earns interest is an example, albeit a poor form of investing, due to historically low interest rates. Trading money today for money in the future by way of interest payments is attune to saying that money today is worth more in the future. How much more depends on many different factors: laws, politics, timing.
If for instance, you purchase government bonds at a rate of 5% for a project that has been put together to fix all of the roads throughout the country but the rate of inflation is 6% during the same time, you have effectively lost money due to the inability to keep up with the underlying value of the money in the future. Inflation has become a very common thing in recent history. Interest rates are driven by the underlying inflation rate thereby keeping the same pace and usually exceeding the rate of inflation to maintain or exceed the same amount of purchasing power. Inflation risks vary country to country as well as timing…it varies.
Varying risks, of which inflation is just one, are captured in a countries risk premium with the amount of interest paid for investment. Essentially, the risk is offset and proportional to the amount of interest paid due to economic factors; payment that is postponed by the investor for a future payment. The risk premium component, the interest rate, may be much higher than the pure interest rate. Future money may not be as valuable as current money.
The same nominal amount of money has a different value based on time. People purchase 30-year bonds but generally make more money due to the time component associated with those investments.
Bond prices go down when interest rates go up – they carry an inverse correlation to each other.
If you purchase a bond for $8,000 today, with a $10,000 pay-out 3-years later, the government will tax the $2,000 increase in value as a ‘capital gain’ and additionally NOT take into account the amount of inflation during that same time that essentially devalued your money.
- You won’t get compensated for the time of waiting
- You get taxed on the capital gain
- You don’t get compensated for inflationary losses
If inflation and capital gains tax exceed the rate of return, you have given your money away and are worse off than if you had never purchased the bond in the first place. Bonds generally carry a much lower gain as they promise a fixed rate of return on a fixed date. Bond holders have a legal right to be paid even if the business is losing money.
How can capital gains be considered an actual gain?
The rate at which you are taxed on a capital gain depends on the country you invest in with the US having much political controversy surrounding the subject.
What is short-term capital gains tax?
A short-term gain equals your ordinary income tax rate – your tax bracket.
What is long-term capital gains tax?
Long-term gains are profits from the sale of an asset held for more than 1-year. The long-term capital gains tax rate is 0%, 15%, or 20% depending on your taxable income and filing status. They are generally lower than short-term capital gains tax rate.
*Note – “collectable assets” are generally taxed at a higher rate than the tables listed above. Watch out for rule exceptions!
What does this mean for you?
- Capital gains taxes can apply on investments, such as stocks or bonds, real estate (though usually not your home), cars, boats and other tangible items.
- The money you make on the sale of any of these items is your capital gain. Money you lose is a capital loss.
- You can use investment capital losses to offset gains. For example, if you sold a stock for a $10,000 profit this year and sold another at a $4,000 loss, you’ll be taxed on capital gains of $6,000.
- The difference between your capital gains and your capital losses is called your “net capital gain.” If your losses exceed your gains, you can deduct the difference on your tax return, up to $3,000 per year ($1,500 for those married filing separately).
- You include your capital gain in your income to figure out what tax rate applies to the capital gain. Capital gains taxes are progressive, similar to income taxes.
Why should you care?
When you are taxed, you are forfeiting many future dollars that would have grown if properly invested over a given amount of time.
Both capital gains and how they are taxed work against you when investing.
$5,000 fewer dollars in tax each year can equate to millions of dollars in future wealth. If $5,000 is reinvested at an average of 10% for 40 years, you’d have an additional $2,660,555 in retirement.
The IRS allows you to shelter the rental income from apartments in the following ways:
- Property depreciation (IRS classification of items at the apartment community)
- Depreciation recapture (a gain from the sale of depreciable capital property reported as income)
- Accelerated cost segregation (this requires a CPA that is savvy with this strategy)
- Mortgage interest payments
- Interest paid on additional loans that were used to improve the property
- One-time capital expenditures “CapEx” (not an ongoing expense)
- 1031 tax deferred property exchange
- Capital gains (when sold, capital gains taxes are imposed by the IRS depending on the amount of money gained from the sale)
- Usually this is 0%–20%
- *There are no capital gains taxes imposed after a refinance
A working professional that makes a salary of $350,000 per year contributes to the IRS in the following way:
- Adjusted Federal Income Tax $92,955
- Social Security $8,239
- Medicare $5,075
- State tax $32,276
- Total tax $138,545
After tax Salary $211,455
If you took the total tax of $138,545 from this example and invested it one time without adding any other contributions and it grew at a 10% rate for 40 years, you’d have an additional $6,270,443.56 in retirement. Much, if not all, of the cash flow that is generated by apartments is sheltered by paper losses. Net losses are a way to show the IRS that your property does not need to pay taxes and the rental income isn’t forfeited to the IRS. A 10% return on your real estate investment may take a 12% return or higher in the stock market after paying capital gains tax.
Wrapping it all up
Robert Kiyosaki said, “It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.”
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- Single Seat Investor: Build Proactive Wealth™ with Passive Apartment Investing – Dominic Teich
- Basic Economics: A Common Sense Guide to the Economy. – Thomas Sowell
- 2020 Capital Gains Tax Rates and How to Calculate Your Bill – nerdwallet.com
- Investment Income and Expenses – IRS.gov
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