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Earnings come from two sources, one of which is the above-mentioned take-home pay. The IRS places take-home pay under the category of “Wages and Salary,” or “ordinary income,” which also includes tips, commission, and bonuses. The taxes you pay on ordinary income depending on your tax bracket or how much you earn in a given tax year. The more you make, the higher your tax bracket.
Then there is the other earnings source, known as capital gains. You’ve probably realized that selling a capital asset generates capital gains. And as you’ve also likely discovered, capital assets consist of property acquired to create value over time, such as houses, boats, and stocks. Stamp collections, art, and baseball cards could also be considered capital assets.
Your capital gains are calculated by subtracting the sales price by the adjusted basis. Delving into the dictionary, “basis” is the original price you paid for that capital asset, plus additional expenses involved. For instance, if you make repairs to a house while you own it, your basis will include the original purchase price plus the added repair expense.
To reiterate, the IRS considers both take-home pay and capital gains as income. Both ordinary income and capital gains taxes are based on take-home pay. However, while ordinary income taxes can be as high as 37%, the tax rate on capital gains won’t reach higher than 20%.
How Long Do You Hold?
With the difference between capital gains and ordinary income in mind, let’s move on to the capital asset holding time. In fact, let’s say that you are a “house flipper,” someone who buys houses, fixes them up, and sells them within six or eight months. While you might earn a good profit from this action, it’s important to know that the IRS dubs those earnings as short-term capital gains. However, if you decide to own your investment houses for longer than a year, the IRS considers profits generated from their sale as long-term capital gains.
What’s the difference? The IRS taxes short-term capital gains at the potentially higher ordinary income tax rate. On the other hand, your long-term capital gains fall under the possibly lower capital gains tax designation.
Additional Tax Issues
Now, once you’ve accepted that your brother-in-law knows what he’s talking about, the other piece of news is that the capital gains you earned from your house, boat, or stock sale will increase your adjusted gross income or AGI.
Returning to the dictionary, AGI consists of your total gross income, less specific deductions. Adding capital gains to that total could push you into a higher tax bracket. But once again, those capital gains are taxed differently from ordinary income, depending on when you sell your capital asset.
All Income is Not Created Equal
Anything you earn — whether salary or asset sale — is considered taxable income in the eyes of the IRS. However, much as you can reduce ordinary income through approved tax deductions, it’s possible to reduce or defer capital gains taxes through reinvestments, exchanges, or other shelters. In short, the more you understand the ins and outs of capital gains and ordinary income, the better prepared you are to lessen your potential tax hit.
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