Contributed by: Dale Shaw, CFP
For affluent investors, capital gains tax is more than a line item on a tax return. It's a lever that can meaningfully impact net investment outcomes, legacy planning, and overall financial efficiency. Yet many investors—even those with considerable portfolios—lack clarity on how the tax is calculated. Understanding the underlying methodology is key to making smarter, more informed financial decisions.
At Granite Harbor Advisors, we frequently work with successful business owners, executives, and families navigating complex portfolios and liquidity events. In these conversations, we often find that understanding the mechanics of capital gains tax is a missing piece that can significantly influence long-term outcomes. This article provides a practical, step-by-step walkthrough to help demystify the process and support better strategic decision-making.
What is Capital Gains Tax?
Capital gains tax is the tax imposed on the profit realized from the sale of an asset, such as stocks, real estate, or a business, when that asset is sold for more than its original purchase price. The amount of tax owed depends on how long the asset was held: short-term capital gains (for assets held one year or less) are typically taxed at ordinary income tax rates, while long-term capital gains (for assets held longer than one year) are generally taxed at lower, preferential rates. Understanding how capital gains tax works is essential for effective investment and estate planning.
Step 1: Determine the Holding Period
The first factor in calculating capital gains tax is understanding how long the asset was held before it was sold. This determines whether the gain is classified as short-term or long-term:
- Short-term: Held for one year or less; taxed at ordinary income rates (up to 37% federally in 2025).
- Long-term: Held for more than one year; taxed at preferential rates of 0%, 15%, or 20% depending on taxable income, or 25% or 28% for Section 1250 real property or collectibles respectively.
For most high-income investors, the long-term rate will likely be 20%, plus potential surcharges.
Step 2: Calculate the Adjusted Cost Basis
The cost basis is the original purchase price of the asset, but it often requires adjustments. Your adjusted basis may include:
- Purchase price of the asset
- Fees or commissions paid at purchase
- Improvements (for real estate)
- Depreciation taken (which reduces basis)
- Costs of sale (which can sometimes be added)
- Step up due to inheritance of assets
The adjusted cost basis is critical because it determines the amount of taxable gain.
Step 3: Compute the Gross Capital Gain
Subtract the adjusted cost basis from the net sales proceeds (what you received after commissions and fees). For example:
- Sale Price: $2,000,000
- Adjusted Basis: $1,200,000
- Capital Gain: $800,000
This is the gross capital gain before taxes.
Step 4: Apply Federal Capital Gains Tax Rates
The IRS utilizes tiered rates based on income and filing status. For example, for those who are married filing jointly in 2025, the following tiers apply:
- 0% for taxable income up to $94,050
- 15% for income between $94,051 and $583,750
- 20% for income above $583,750
High earners may also owe the 3.8% Net Investment Income Tax (NIIT)*, bringing the effective federal rate to 23.8%. NIIT applies to individuals with modified adjusted gross income over $200,000 (single filers) or $250,000 (married filing jointly). It covers investment income such as capital gains, dividends, interest, and passive rental income.
*Topic no. 409, Capital gains and losses
Step 5: Consider State Taxation
Texas, along with several other states, does not impose a state income tax, which provides a significant advantage to residents. However, individuals with property or nexus in states that do may face capital gains taxes in those jurisdictions. It's crucial to factor in state-level tax exposure during planning.
Step 6: Factor in Special Situations
Certain strategies or asset types can alter the capital gains calculation:
- Qualified Small Business Stock (QSBS): Up to 100% of gains may be excluded if criteria are met.
- 1031 Like-Kind Exchanges: For real estate, gains can be deferred when proceeds are reinvested in similar property.
- Opportunity Zones: Deferral and potential exclusion of gains if reinvested in designated areas.
- Charitable Gifting: Donating appreciated securities can eliminate capital gains tax and generate a deduction.
Illustrative Example
Consider a Houston-based couple with $3 million in annual income who sell a long-held investment property:
- Sale Proceeds: $2,500,000
- Adjusted Basis: $1,000,000
- Long-Term Gain: $1,500,000
- Federal Tax: $1,500,000 x 20% = $300,000
- NIIT: $1,500,000 x 3.8% = $57,000
- Total Tax on the Property: $357,000 (no state tax in Texas)
This example underscores why proactive planning is essential to mitigate erosion.
Why Capital Gains Planning Matters
Understanding how capital gains tax is calculated opens the door to purposeful decision-making. It informs:
- Timing of asset sales
- Harvesting of gains and losses
- Strategic gifting or estate transfers
- Selection of account types for tax deferral or exclusion
At Granite Harbor Advisors, we build capital gains strategy into the broader architecture of our clients’ financial plans. Whether it’s coordinating with CPAs to optimize tax treatment, identifying private investments with favorable tax characteristics, or utilizing advanced trust structures, our approach is designed to help preserve more of what clients earn.
Conclusion
Capital gains tax is complex, but it doesn’t have to be opaque. With the right partner, you can move from reactive tax reporting to proactive tax strategy. If you’re facing a sale, liquidity event, or portfolio reallocation, now is the time to understand how your gains are calculated—and how your plan can be tailored to preserve more of your success.
References:
- Topic no. 409, Capital gains and losses. Retrieved from https://www.irs.gov/taxtopics/tc409