A Capital Gain is, basically, the profit that you make when you sell your investment property or stock.
From there, it becomes more complex.
Your Capital Gains are the difference between what you paid for the property (or stock) and what you sold it for.
Except with real estate there are some adjustments to be made.
First, you can deduct from the selling price most of the costs of the transaction. These are listed on your HUD-1 Settlement Statement (AKA "Seller's Statement"). Also, there might be some expenses that were paid out of closing that were also expenses of the sale.
That takes care of the amount that you received for the property, your Net Sales Proceeds.
Now, what you deduct from your Net Sales Proceeds is called your Adjusted Basis in the property.
But for now, a quick description of your Adjusted Basis in the property is the amount that you paid for the property, plus any capital improvements made to the property, and minus any depreciation claimed.
CG = NSP - (OPP + CI - D), where
CG is Capital Gains,
NSP is your Net Sales Price,
OPP is your Original Purchase Price,
CI is Capital Improvements, and
D is Depreciation taken
For example, you purchased a Duplex ten years ago for $200,000. You added two garages for $30,000 and replaced some fixtures for $20,000.
You have taken $65,000 Depreciation on the Duplex and you have taken $8000 Depreciation on the garages, and you have taken $15,000 Depreciation on the fixtures.
Now you sell the Duplex for $400,000 and you have $10,000 in transaction costs.
CG = NSP - OPP + CI - D
CG = (400,000 - 10,000) - [200,000 + (30,000 + 20,000) - (65,000 + 8,000 + 15,000]
CG = 390,000 - (200,000 + 50,000 - 88,000)
CG = 390,000 - 162,000
CG = 228,000
Your Capital Gains on that transaction is $228,000.
If you had held the property for one year or less, the Capital Gains would be classified as Short-Term Capital Gains.
Short-Term Capital Gains are taxed at the same rate as your individual tax rate for the tax year in which the transaction took place.
But if you held the property for at least a year and a day, the Capital Gains are classified as Long-Term Capital Gains.
Long-Term Capital Gains are taxed at different rates for different taxpayers, depending on the amount of their other income, either 0%, 15% or 20%.
But part of your Capital Gains will be taxed at the Capital Gains tax rate, and part of it will be taxed as Depreciation Recapture, and at what will probably be a higher rate.
Here is a video that may also help explain it:
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