Navigating State Capital Gains Tax Laws

Did you know that your state of residence could determine whether you pay anywhere from 0% to more than 13% in capital gains taxes? These taxes vary by state and can significantly affect your net investment profits. Understanding how federal and state tax laws impact your gains is an essential part of smart financial planning.

Whether you're earning from real estate, stocks or other investments, knowing your state’s tax rules can help you make a plan to maximize any profits and minimize your tax liability. Factoring in potential losses can also offset gains, reducing what you owe and boosting your bottom line.

Let’s take a closer look.

UNDERSTANDING CAPITAL GAINS TAX BASICS

Capital gains taxes are levied on the profit realized from selling a non-inventory asset, such as stocks, bonds or real estate, when the sale price exceeds the purchase price. This profit is referred to as a realized gain. These gains are categorized into short-term and long-term capital gains, each subject to different tax treatments.

Short-term capital gains apply to assets held for one year or less and are taxed as ordinary income, with rates up to 40.8% (37% +3.8% Net Investment Income Tax) federally, depending on your adjusted gross income. Long-term capital gains are for assets held longer than one year and benefit from significantly lower tax rates, known as long-term capital gains rates. The Internal Revenue Code outlines these rates based on taxable income, encouraging long-term investments.

Understanding these distinctions is important for tax purposes, as it affects how much you owe the IRS when filing your tax return.

FEDERAL VS. STATE CAPITAL GAINS TAXES

The federal government establishes baseline capital gains tax rates, but each state imposes its own rates and rules, adding complexity to tax planning. At the federal level, long-term capital gains tax rates are determined by income brackets tied to your adjusted gross income and taxable income.

State capital gains taxes vary widely. Some states align closely with federal rates, while others impose higher taxes or additional surcharges. For instance, California taxes long-term capital gains as ordinary income, with rates up to 13.3%. In contrast, states like Alaska and Florida do not impose state income taxes, resulting in no additional state capital gains taxes.

Comparison of Federal and State Capital Gains Taxes

Federal Capital Gains Taxes:

• Long-term rates of 0%, 15% or 20%
• Based on taxable income brackets
• Short-term capital gains taxed as ordinary income

State Capital Gains Taxes:

• Rates range from 0% to 13.3%
• Some states tax gains as ordinary income; others have no state income tax
• May affect your net investment income

Getting to know these differences can help you understand state taxes and how they might impact your overall tax burden.

IMPACT ON INVESTMENT DECISIONS

State capital gains taxes significantly influence decisions about where and when to invest or sell assets. High taxes in certain states may discourage investors from selling assets like real estate due to the substantial tax burden. On the other hand, states with more favorable tax laws can attract investors looking to maximize realized gains.

To navigate these tax variations, strategic investment and tax planning is vital. Timing asset sales and understanding how state taxes impact your income can help minimize tax liabilities. Strategies like tax-loss harvesting or using tax-advantaged accounts can be particularly effective. For instance, offsetting a capital gain with a capital loss in the same tax year reduces taxable income. Additionally, it’s crucial to understand how capital gains taxes can influence retirement income and Social Security benefits, as this can impact long-term financial planning.

STATE-BY-STATE OVERVIEW OF CAPITAL GAINS TAX RATES

Understanding how each state handles capital gains taxation is one essential part of effective financial planning. Your taxpayer status in a specific state directly impacts the amount of capital gains income you retain after selling assets.

Here’s a deeper dive into state-specific tax rates:

States with the Highest Capital Gains Tax Rates

Some states tax capital gains as ordinary income, applying the same rates used for regular earnings. This approach can result in substantially higher taxes on your capital gains.

• California: Top marginal tax rate of 13.3%, impacting both long-term and short-term capital gains
• New York: Rates up to 10.9%
  • New York City: Rates up to 3.876%
• Oregon: Rates up to 9.9%

In these states, the combination of federal and state taxes can significantly reduce the net proceeds from your investments.

States with the Lowest or No Capital Gains Tax

Some states offer more favorable conditions by taxing capital gains at lower rates or not at all. In most cases, if a state does not impose state income tax, it results in zero state capital gains tax.

States with no state income tax include:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

It’s important to note a few caveats, however, with these states:

• New Hampshire taxes interest and dividends income, although the 4% rate in tax year 2024 drops to 3% in 2025 and another one percent every year until it’s expected to be phased out entirely in 2028
• Tennessee has a limited tax on certain dividends and capital gains
• Washington has a capital gains tax on high-income earners in the form of a 7% tax on the sale or exchange of long-term capital assets

Investing or selling assets in these states can help you keep more of your after-tax profits, especially on long-term capital gains.

NOTABLE STATE-SPECIFIC EXEMPTIONS AND ADDITIONAL TAXES

Certain states provide exemptions or impose additional taxes that investors should be aware of, such as:

• Arizona excludes 25% of net long-term capital gains, with the remainder taxed at ordinary rates.
• Hawaii has a maximum rate on long-term gains of 7.25%.
• Massachusetts stipulates short-term gains have an 8.5% rate (plus 4% if income is greater than $1,053,750) and long-term gains have a rate of 5% (plus 4% if income is greater than $1,053,750).
• Minnesota's 10.85% top marginal effective rate on capital gains income includes a 1% tax on net investment income exceeding $1 million.
• Montana has a maximum rate on long-term gains of 4.1%.
• New Jersey does not recognize capital loss carryovers.
• New Mexico currently excludes the greater of $1,000 or 40% of a taxpayer's net long-term capital gains.
• North Dakota offers a 40% exclusion.
• Pennsylvania does not recognize capital loss carryovers.
• South Carolina excludes 44% of net long-term capital gains.
• Washington State has a recently enacted capital gains tax, which imposes a 7% tax on certain long-term capital gains exceeding $270,000, with exemptions for real estate and assets held in certain retirement accounts.
• Wisconsin allows a 30% deduction on net long-term capital gains and a 60% deduction for farm assets.

IMPACT ON REAL ESTATE INVESTMENTS

State capital gains taxes can play a significant role in real estate investment decisions, particularly when selling property in high-tax states. Elevated property and capital gains taxes can reduce profitability, making it essential to understand state-specific rules. Key considerations include exemptions for primary residences and like-kind exchanges under Section 1031 of the Internal Revenue Code.

In some areas, local income taxes add another layer of complexity. Being informed about these factors allows for better planning to potentially defer taxes and help you make decisions around asset allocation, timing of sales and even residency.

STRATEGIES FOR MANAGING CAPITAL GAINS TAXES

Here are some strategies to consider as you look to enhance any profits from the sale of your investments:

Tax-Loss Harvesting: Selling underperforming assets to offset gains from profitable ones can reduce your taxable capital gain. A tax loss harvesting strategy is particularly useful for short-term capital gains, which are taxed at higher rates. Additionally, deferring gains by holding assets for more than one year converts short-term gains into long-term capital gains, taxed at lower rates.

Tax-Advantaged Accounts: Utilizing accounts like IRAs and 401ks allows investments to grow tax-deferred or even tax-free, in the case of a Roth account, significantly impacting long-term wealth accumulation.

Benefits:

• Tax-Deferred Growth: Investments can grow without immediate tax implications, postponing income tax until withdrawal
• Reduced Gains Tax: No taxes on investments within these accounts until withdrawal, which may occur in a lower tax bracket during retirement income years

Limitations:

• Contribution Limits: Annual limits restrict how much you can invest
• Early Withdrawal Penalties: Withdrawing funds before retirement age may result in penalties and additional taxes
• Distributions are typically taxed as ordinary income

Timing and Asset Allocation: Smart timing and strategic asset allocation can significantly reduce tax liability. Selling assets during a low-income year may place your capital gains in a lower tax bracket, improving your net income for the year. To make your investment decisions more tax-efficient, align your strategies with current tax laws and regulations.

MAXIMIZING INVESTMENT REALIZED GAINS AMIDST VARIED TAX LAWS

Understanding state capital gains tax laws is one key to helping you maximize your realized investment gains. Knowing these state-specific tax rules can guide where and how you invest, helping you retain more of your profits. Managing estimated tax payments proactively also reduces the risk of surprises during tax season.

Navigating these laws isn’t just about compliance—it’s a smart strategy. Effective tax management can help optimize your portfolio, improve cash flow and help you reach your financial goals. That’s where we come in! Our planners can coordinate with your tax professional to help develop tax-efficient strategies that align with your long-term objectives.