Capital Gains Tax Explained (What It Is & How to Avoid Capital Gains Tax)

When you invest your money, your goal is to build wealth or savings. This means that you likely want to keep as much of the money you’re earning as possible and pay fewer capital gains taxes.

As an investor, it’s important to understand how capital gains are taxed and what that means for your financial situation. If you made a profit selling stocks or another asset, you may owe capital gains taxes. Fortunately, there are ways to reduce your tax bill and save money.

As part of your investment strategy, you’ll want to know how to avoid capital gains tax to keep more of your money working for you. Read on to learn more about how to avoid capital gains tax on property and stocks.

What are capital gains? 

A common question from filers is, what is the capital gains tax? Well, to start, the IRS deems taxable income as one of two types: ordinary income or capital gain income. To help you determine where your tax situation falls, income that is considered ordinary includes:

• Salary or hourly wages
• Interest income
• Self-employment income (e.g., freelancing or otherwise running your own business)
• Rental income

On the other hand, capital gains income results from the selling of certain personal items for more than you paid for them. Examples of transactions that can trigger capital gains tax include:

• Stocks sales
• Mutual fund sales
• Home sales

Capital Gains vs. Losses

To determine the extent of a capital gain or loss, you simply subtract your cost of the asset you sold from its sales price. 

If your cost is less than the sales price, you have a capital gain. If your cost exceeds your sales price, you have a capital loss. 

You can deduct up to $3,000 in capital losses from your income. If your capital losses are more than $3,000, you can carry them forward to the next tax year.

How are capital gains taxed?

In general, top ordinary income tax rates exceed top capital gains tax rates. Consequently, you’d prefer income to be from a capital gains transaction over an event triggering ordinary income.

Short vs. long-term capital gains

There are two kinds of capital transactions: short-term and long-term. Understanding short vs. long-term capital gains is a key aspect of how to avoid capital gains tax on stocks and other assets.

Short-term transactions occur if the sale of an asset happens in a year or less after the purchase. Short-term capital gains are taxed the same as ordinary income. 

Long-term capital gains occur when the taxpayer owned the asset for more than one year, and are taxed at capital gains tax rates. These long-term gains will be taxed at 0%, 15%, or 20%, depending on your income.

How to avoid capital gains taxes: 4 strategies

While you can’t always avoid capital gains taxes, there are ways to reduce your tax liability and save money. Being a smart investor is a key part of avoiding capital gains taxes. If you want to  learn how to avoid paying capital gains tax, below are a few popular strategies.

Focus on long-term investments

Because long-term and short-term capital gains are taxed differently, how you invest your money impacts your tax bill. Long-term investments are often taxed at a lower rate, so, in many cases, focusing on long-term investments can help you save on taxes.

Whether this strategy is a worthwhile option for you will depend on your investment portfolio. But in theory, if you’re trying to pay lower capital gains taxes, you’d hold the assets for a minimum of one year before selling. Prematurely selling assets for a profit increases your short-term capital gains, which often results in a higher capital gains tax rate.

Practice tax loss harvesting

Tax loss harvesting is a strategy you can use to reduce your capital gains tax liability. The basic idea is that you can use capital losses to offset capital gains, lowering the total capital gains tax you owe.

While tax loss harvesting can be a smart strategy, there are some caveats. Tax loss harvesting only works with certain types of investments, which excludes tax-deferred retirement accounts.

Your capital losses must first be used to offset capital losses of the same type — so short-term losses are used to offset short-term gains first. Any remaining capital losses can be used to offset long-term gains.

If your capital losses exceed your capital gains, you can use it to offset up to $3,000 of ordinary income. If your losses exceed your gains by more than $3,000, any excess will carry over into future years.

Invest in tax-deferred retirement plans

Investing within a tax-deferred retirement plan can help you avoid capital gains taxes for an extended period. These capital gains aren’t taxed until you retire and begin withdrawing money from the account.

There are several benefits of investing in tax-deferred retirement plans. You may find yourself in a lower tax bracket when your capital gains are taxed at retirement. Plus, your retirement account can continue its tax-deferred growth.

You can also use a Roth IRA or 401(k) to invest. As long as you follow certain rules, your capital gains won’t be taxed even when you withdraw them.

Give appreciated stock to charity

Another way to avoid taxes on stocks and other investments is to donate them to charity.

Did you know that you could donate appreciated stock instead of cash to your charity of choice? When you donate profitable investments to a charitable organization, you don’t have to pay capital gains tax, and usually, neither does the charity. You’ll also receive a tax deduction for your charitable donation.

Keep in mind that charitable donation tax deductions have limits. For tax years 2023 and 2024, charitable cash contributions generally can’t exceed 60% of your adjusted gross income.  In some situations, you could be limited to 20%, 30%, or 50% of your adjusted gross income as well.

Either way, you don’t need to worry about knowing how to calculate capital gains if you sold personal property. No matter what moves you made last year, TurboTax will make them count on your taxes. Whether you want to do your taxes yourself or have a TurboTax expert file for you, we’ll make sure you get every dollar you deserve and your biggest possible refund – guaranteed.