Throughout the year, it might not be uncommon for you or your business to experience some kind of large gain. You also might earn income from an investment you made. Both of these earnings are great for your business, but they come with some tricky tax scenarios. Check out the rest of this article to learn how best to deal with capital gains and investment income!
What Classifies as a Capital Gain or Investment Income?
If you don’t know what a capital gain is, don’t feel bad, because you aren’t alone! The definition is a little confusing, but a capital gain is classified as an increase in value associated with a capital asset. The asset may increase in value at anytime, but it isn’t officially recognized as a gain until the asset is sold. Capital assets generally refer to land and other larger investments.
In simpler terms, a capital gain is the profit you earned on the sale of a significant asset. This calculation is quite easy to make – just subtract the price for which you purchased the asset from the price for which you sold it.
Capital gains are considered investment income, but they are taxed at a special rate, which is generally 15%. Investment income includes more than just capital gains, though, as it can also refer to income earned from dividends and interest payments.
The distinction between capital gain and investment income is actually very important because the two are taxed at different rates. Because of this, you have to be careful and make sure you’re correctly classifying all of your income as what it actually is!
One key exception to capital gains comes with short-term gains. This happens when an asset is purchased, held, and sold within a year. In this scenario, any income earned from the sale would be classified as regular income despite the asset being a capital asset. In order for a gain to be a capital gain, the asset in question must have been held for more than a year.
Impact to Your Taxes
Now that you know that capital gains and investment income carry different tax rates, there is a good reason to ensure everything is properly classified. You might realize that you would pay the same value in taxes regardless of how you classify, but this can create a negative effect when you try to file in a future year. Here is how each form of income is taxed:
- Capital Gains – Capital gains have their own tax bracket based upon your net income. If you filed as single and earned $38,600 or less (doubled for joint filers), you won’t pay a dime for capital gains. Anyone earning more than that but less than $425,800 will pay 15% ($479,000 limit for joint filers). If you earned more than that in a year, capital gains would be taxed at 20%. Most taxpayers will face a 15% capital gains tax rate.
- Dividends – Dividends differ on how they’re taxed depending upon the company from which the shares originate and how long you held the stocks. If the company from which you received dividends originates in the U.S. and you held the stocks for at least 61 days out of the 121-day period surrounding the ex-dividend date, then you’ll receive a preferential rate of 15%. The ex-dividend date is when the company receives a dividend rather than the person who purchased the stock. For all other dividend scenarios, you’ll pay a tax rate equal to your income tax rate, with a sliding bracket based on your total earnings.
- Interest – Interest income is viewed as regular income, and will therefore be taxed at the same rate as the rest of your income. This is determined by your total earnings for the year, with most people paying 22%-32% in 2018. There is one exception made for interest earned from municipal and state bonds. In these situations, the interest is completely tax free!
- Capital Losses – Capital losses certainly do not classify as income, but they can be used to offset capital gains you earn. This is also why it is important to properly classify capital assets, so that you can properly claim capital losses in future years. You can claim up to $3,000 each year in capital losses to offset any capital gains you earned. Your capital losses will carry over to future years, so you can continue to offset future capital gains with a loss you made years ago.
Professional Accountants to Simplify Everything!
If you really think about it, it makes a lot of sense to classify something as a capital gain when you can. The 15% tax rate that comes with capital gains is very beneficial, as it is often significantly below overall income tax rate you might pay. This especially comes in handy when you start reaching higher income thresholds, prompting a heftier tax rate.
Despite the benefit from paying a lower tax, you want to make sure all of your investment income is properly classified. Failing to do so can result in a fine. Nearly all forms of interest income are taxed like regular income, and only qualified dividends will be taxed at the preferential 15% rate.
Another important reason to properly claim capital gains are the capital losses you can claim in future years! $3,000 is a significant chunk to detract from you capital gains every year, so you’ll want to ensure you properly classify so you can redeem it in future years. Remember that your capital losses carry on from year to year!
It isn’t always obvious what classifies as regular investment income and what is a capital gain. Fortunately for you, you can seek the counsel of a professional accountant that can clearly distinguish between the two! You can explain your tax and income situation, and receive expert advice on how to classify each form of income you have. There simply isn’t a better way to ensure you’re doing your taxes right!