Understanding Capital Gains Tax in Texas

Texas offers a unique tax advantage for investors – there is no state income tax, which means capital gains are not taxed at the state level. Unlike investors from states that impose their own capital gains taxes, Texas residents only need to account for federal capital gains taxes when selling assets like real estate, stocks or business interests.

For high-income earners, federal capital gains taxes can still be significant. Understanding the federal tax implications – and utilizing strategies like the primary residence exemption or 1031 exchanges for real estate – can help optimize after-tax outcomes.

Let’s take a closer look.

THE BASICS OF CAPITAL GAINS TAX FOR TEXAS RESIDENTS

To effectively navigate capital gains taxes in Texas, it’s important to first grasp the basics of both state and federal obligations. Understanding essential terms and definitions is key before diving into tax planning strategies.

• Capital gain: The profit realized when you sell a capital asset, such as stocks, bonds or real estate, for more than its purchase price
• Capital loss: The loss incurred when you sell a capital asset for less than what you paid for it
• Short-term capital gains: Gains from the sale of assets held for one year or less, taxed at your ordinary income tax rate
• Long-term capital gains: Gains from the sale of assets held for more than one year, taxed at lower rates than short-term gains
• Taxable income: Your total income subject to taxes after accounting for deductions and exemptions
• Tax bracket: The range of income levels taxed at specific rates (higher income typically faces higher tax rates)
• Adjusted gross income: Your gross income minus certain adjustments, used to determine your taxable income
• Tax liability: The total amount of tax owed to the government
• Investment property: Real estate purchased to earn a return through rental income, future resale or both

Federal tax rates can have a significant impact on your investment returns. For higher-income investors, your tax bracket could lead to higher capital gains rates. Understanding the difference between short-term and long-term capital gains is crucial, as holding assets for more than a year can reduce the tax rate on gains and potentially optimize your overall returns. Since Texas has no state capital gains tax, federal tax obligations are your primary concern.

FEDERAL CAPITAL GAINS TAX RATES

Current federal capital gains tax rates are structured to favor long-term investments:

• Short-term capital gains: Taxed at ordinary income tax rates, which range from 10% to 37%, depending on your taxable income and filing status
• Long-term capital gains: Taxed at preferential rates of 0%, 15% or 20%
• Net investment income tax: Additional NIIT of 3.8% for taxpayers with income greater than $200,000 (single or head of household filers), $250,000 (married couples filing jointly or qualifying surviving spouse with dependent child) or $125,000 (married filing separately)

Here's how long-term capital gains rates apply to different income brackets:

• 0% Rate
  • Single filers and married filing separately with taxable income up to $47,025 in 2024 or $48,350 in 2025
  • Married couples filing jointly or qualifying surviving spouse with taxable income up to $94,050 in 2024 or $96,700 in 2025
  • Head of household with taxable income up to $63,000 in 2024 and $64,750 in 2025
• 15% Rate
  • Single filers with taxable income between $47,025 and $518,900 in 2024 or between $48,350 and $533,400 in 2025
  • Married filing separately with taxable income between $47,025 and $291,850 in 2024 or between $48,350 and $300,000 in 2025
  • Married couples filing jointly or qualifying surviving spouse with taxable income between $94,050 and $583,750 in 2024 or between $96,700 and $600,050 in 2025
  • Head of household with taxable income between $63,000 and $551,350 in 2024 or between $64,750 and $566,700 in 2025
• 20% Rate
  • Single filers with taxable income over $518,900 in 2024 or $533,400 in 2025
  • Married filing separately with taxable income over $291,850 in 2024 or $300,000 in 2025
  • Married couples filing jointly or qualifying surviving spouse with taxable income over $583,750 in 2024 or $600,050 in 2025
  • Head of household with taxable income over $551,350 in 2024 or $566,700 in 2025

There are a few other exceptions where capital gains may be taxed at rates greater than 20%, such as gains from certain qualified small business stock, collectibles and real property.

While the federal tax structure remains the same for all U.S. residents, having no state capital gains tax in Texas offers a distinct advantage, allowing investors to keep more of their gains compared to those in states where state capital gains taxes are required.

HOW TEXAS TAXES CAPITAL GAINS

Here's what investors in Texas need to understand:

• Federal capital gains rates: Long-term capital gains (for assets held over a year) are taxed at federal rates ranging from 0% to 20%, depending on your taxable income and filing status. Short-term capital gains (for assets held one year or less) are taxed as ordinary income, with rates up to 37%.
• Primary residence exemption: If the property sold is your primary residence, you may qualify for an exemption that allows you to exclude up to $250,000 of the gain from your income if you're single, or up to $500,000 for married couples filing jointly, provided you’ve lived in the home for at least two of the past five years.

While Texas doesn't add state taxes to your capital gains, it's essential to plan for federal tax obligations. Strategies such as utilizing the primary residence exemption, timing your sales to align with favorable tax rates or considering a 1031 exchange for investment properties can help mitigate these taxes. Consulting with a tax professional can help you with personalized guidance tailored to your situation.

STRATEGIES FOR MINIMIZING CAPITAL GAINS TAX LIABILITY

Reducing your capital gains tax liability isn't just about understanding the tax – it's about implementing effective strategies that align with your financial goals. Here are key approaches to consider:

Embrace Long-Term Investing

One of the most straightforward ways to minimize capital gains tax is by focusing on long-term investments. Holding assets for more than one year qualifies you for the lower long-term capital gains tax rates, which are significantly more favorable than short-term rates. This strategy not only reduces your tax rate but also allows your investments more time to potentially grow.

Implement Tax-Loss Harvesting

Tax-loss harvesting works by strategically selling investments that have declined in value. The losses realized can offset capital gains from other investments. If your losses exceed your gains, you can even offset up to $3,000 of ordinary income annually, with any additional losses carried forward to future tax years.

Here's what to consider so you can use tax-loss harvesting effectively:

• Identify underperforming assets: Review your portfolio to pinpoint investments that haven't performed as expected
• Sell to realize losses: Selling these assets locks in the capital loss, which can then offset gains elsewhere
• Reinvest wisely: To maintain your investment strategy, reinvest the proceeds in assets that align with your goals but aren't substantially identical
• Mind the wash-sale rule: Avoid purchasing the same or substantially similar asset within 30 days before or after the sale so your losses can remain deductible

Tax-loss harvesting requires careful planning and timing. When used effectively, it can enhance your after-tax returns and contribute to a more tax-efficient portfolio.

Consider 1031 Exchanges

For real estate investors, a 1031 exchange offers a powerful tool to potentially defer capital gains taxes. This provision allows you to sell an investment property and reinvest the proceeds into a like-kind property, deferring the capital gains tax liability.

Key aspects of a 1031 exchange include:

• Like-kind property: The replacement property must be of the same nature or character
• Strict timelines: You have 45 days to identify potential properties and 180 days to complete the exchange after selling your original property
• Qualified intermediary: An independent party must facilitate the exchange to comply with IRS regulations

By leveraging a 1031 exchange, you can continue allowing your real estate investments to grow without the immediate tax impact, potentially preserving more capital for future opportunities.

Use Tax-Advantaged Accounts Strategically

Tax-advantaged accounts, such as 401ks and individual retirement accounts, offer a smart way to help minimize the immediate tax impact of capital gains. These accounts are designed to let your investments grow without triggering taxes until specific conditions are met, making them a valuable tool for long-term financial planning. 

Here are some other advantages: 

• Tax-deferred growth: Investments held within these accounts accumulate earnings, including capital gains, without being taxed immediately. You only pay taxes when you withdraw funds. 
• Lower taxable income: Contributions to traditional IRAs and 401ks can reduce your taxable income in the year of contribution, potentially keeping you in a lower tax bracket. 
• Optimized withdrawals: By planning withdrawals strategically during retirement – when your income may be lower – you can reduce the overall tax burden on your investments. 

A Texas Advantage

Texas residents can maximize the benefits of tax-advantaged accounts like 401ks and IRAs even more, thanks to the state’s lack of income tax. Your investments grow tax-deferred, and with no state-level taxes to worry about, withdrawals are more tax-efficient. This means more of your money stays working for you, both while it’s invested and when you’re ready to access it.

Careful management of contributions and withdrawals not only supports tax efficiency but also aligns with long-term financial goals, whether you're planning for retirement or optimizing your resources for family and future investments. 

Timing Asset Transactions

The timing of when you realize capital gains can significantly impact your tax liability. By strategically planning asset sales, you can optimize tax outcomes and enhance your financial position.  

Here’s how: 

• Income management: Selling assets during years when your taxable income is lower may result in a reduced tax rate on capital gains. 
• Long-term planning: Holding investments for longer periods may align with federal benefits for long-term capital gains. 
• Avoiding tax spikes: Spreading out the sale of large assets over multiple years can prevent a substantial increase in taxable income in a single year. 

Strategies to manage the timing of asset sales include: 

• Installment sales: Receiving payments over time can spread out capital gains, potentially keeping you in a lower tax bracket. 
• Charitable contributions: Donating appreciated assets can provide tax deductions while supporting causes you care about. 
• Like-kind exchanges: Although limited, certain exchanges can defer capital gains taxes.

THE IMPORTANCE OF PROFESSIONAL FINANCIAL ADVICE

Navigating the complexities of capital gains tax requires more than just knowledge – it demands strategic planning and professional insight. Financial advisors play a pivotal role in helping you manage capital gains tax liabilities, helping ensure that your investment decisions align with both your short-term needs and long-term goals.

Role of Financial Advisors in Managing Tax Liabilities

Financial advisors bring a wealth of expertise to the table, particularly in tax planning and investment strategies. They can help you:

• Optimize your investment portfolio: By aligning your investments with tax-efficient strategies, advisors can help you design a portfolio that seeks to enhance your after-tax returns.
• Implement tax-reduction strategies: Advisors are well-versed in techniques like tax-loss harvesting and can identify opportunities you might overlook.
• Stay updated on tax laws: Tax regulations are constantly evolving. Advisors keep on top of changes that could impact your investments and help adjust your strategies accordingly.
• Coordinate with tax professionals: Advisors often collaborate with tax attorneys or certified public accountants to provide comprehensive support.

Every individual's financial situation is unique. Personalized guidance helps ensure that strategies are tailored to your specific circumstances.

EMPOWER YOUR FINANCIAL FUTURE TODAY

Understanding and managing capital gains tax is not just a matter of compliance – it's a critical component of your financial success. 

But don't navigate these complexities alone.  Edelman Financial Engines is here to provide personalized guidance and strategies tailored to your unique situation. Along with your qualified tax professional, our experienced financial planners can help you effectively manage capital gains tax planning to better understand your tax liability and empower you to take control of your financial future.

Contact Edelman Financial Engines today to start a conversation about how we can support your financial journey and help you keep more of what you've earned.

Find a financial advisor in Austin

Find a financial advisor in Dallas

Find a financial advisor in Houston

Find a financial advisor in San Antonio

Find a financial advisor in Sugar Land

Find a financial advisor in The Woodlands

Find a financial advisor in West Houston