Capital Gains

What Is a Capital Gain?

A capital gain refers to the profit earned from the sale of a capital asset, such as stocks, real estate, or other investments. It represents the difference between the purchase price (also known as the "basis") of the asset and the selling price. When an individual or entity sells an asset for a price higher than its initial purchase price, they realize a capital gain.

Capital gains can be categorized into two main types: short-term capital gains and long-term capital gains. The distinction between the two depends on how long the asset was held before it was sold. Short-term capital gains apply to assets held for one year or less, while long-term capital gains apply to assets held for more than one year.

Capital Gains Explained

A capital gain refers to the increase in the value of a capital asset when it is sold. In simple terms, it occurs when you sell an asset for more than what you originally paid for it. This concept applies to a wide range of assets, including investments like stocks, bonds, and real estate, as well as personal-use items like furniture or vehicles.

Capital gains are realized by calculating the difference between the original purchase price and the selling price of an asset. The Internal Revenue Service (IRS) may impose taxes on capital gains in specific situations. Typically, these gains are recognized at the time when the asset is sold. Capital gains are commonly associated with investments due to their price volatility, but they can also apply to any item or property sold for a price higher than the original purchase cost, such as a house or furniture.

Capital gains can be categorized into two main types:

1. Short-term capital gains. These gains are realized when you sell an asset that you’ve held for one year or less.

2. Long-term capital gains. These gains occur when you sell an asset that you’ve held for more than one year.

Both short-term and long-term capital gains must be reported on your annual tax return. It’s crucial to understand this distinction, especially for day traders and those who frequently engage in online market trading.

It’s important to note that realized capital gains are taxable events, meaning you may owe capital gains taxes when you sell an asset. On the other hand, unrealized gains and losses, also known as paper gains and losses, represent changes in an investment’s value but do not trigger immediate taxation. For instance, if you own stocks that have increased in value but haven’t sold them yet, those gains are considered unrealized capital gains and are not subject to taxation until you sell the stocks.

What Is the Capital Gains Tax?

A capital gains tax is a tax imposed on the profit earned by an investor when they sell an investment. This tax is applicable for the tax year in which the investment is sold.

The rates for long-term capital gains tax in the 2022 and 2023 tax years vary based on the filer’s income and are set at 0%, 15%, or 20% of the profit. These rates are subject to annual adjustments. The specific rate applied depends on the filer’s income bracket, and there are different income thresholds that determine which rate applies.

For long-term capital gains, the investment must be owned for at least one year to qualify for these tax rates. On the other hand, if the investor sells the investment within one year of acquiring it, they will be subject to the short-term capital gains tax rate. The short-term capital gains tax rate is determined by the individual’s ordinary income bracket. Generally, short-term capital gains are taxed at higher rates than long-term capital gains, especially for individuals with higher incomes.

Assets Eligible for Capital Gains

Capital gains tax treatment applies to a variety of assets, providing investors and taxpayers with clarity on which holdings are eligible for this tax treatment. Here is a list of assets that are generally eligible for capital gains tax treatment:

1. Stocks. Ownership in companies through shares of stock can yield capital gains when these shares are sold at a profit.

2. Bonds. Investments in bonds, both corporate and government, can result in capital gains upon their sale.

3. Jewelry. Valuable jewelry items, such as rings, necklaces, and gemstones, are eligible for capital gains tax treatment when sold for a profit.

4. Cryptocurrency (including NFTs). The digital assets of cryptocurrency, including non-fungible tokens (NFTs), fall under the capital gains tax regime when they are sold at a profit.

5. Homes and Household Furnishings. Capital gains tax can apply to the sale of residential properties, as well as certain household furnishings, if they appreciate in value.

6. Vehicles. Motor vehicles, such as cars and motorcycles, may be subject to capital gains tax when sold for a profit.

7. Collectibles. Valuable collectible items, such as rare coins, stamps, or memorabilia, are eligible for capital gains tax treatment when sold at a gain.

8. Timber. Gains realized from the sale of timber from forested properties can qualify for capital gains tax treatment.

9. Fine Artworks. Works of fine art, including paintings, sculptures, and other artistic creations, can generate capital gains when sold for a profit.

It’s important to note that not all assets are eligible for capital gains tax treatment. Here are some assets that are typically not eligible:

1. Business Inventory. Inventory held by businesses for the purpose of resale is not eligible for capital gains tax treatment.

2. Depreciable Business Property. Property used for business operations that depreciates over time is generally not eligible for capital gains treatment.

3. Real Estate Used by Your Business or as a Rental Property. Real estate properties used for business operations or rented out are typically subject to different tax rules, such as depreciation and rental income reporting.

4. Copyrights, Patents, and Inventions. Intellectual property rights like copyrights, patents, and inventions are generally not considered for capital gains tax purposes.

5. Literary or Artistic Compositions. Original literary or artistic works, such as books, music, and films, are not typically subject to capital gains tax when sold.

How Does the Capital Gains Tax Work?

The capital gains tax operates under specific rules and principles, which are crucial for individuals and investors to understand. Here’s how the capital gains tax works.

1. Realization of Gains. The capital gains tax is triggered when taxable investment assets, such as stock shares, are sold. It’s important to note that this tax does not apply to unrealized gains or investments that have not been sold. In other words, you won’t incur capital gains taxes until you sell the assets, regardless of how long you’ve held them or how much their value has increased.

2. Distinction between Short-Term and Long-Term Gains. In the United States, current federal tax policy distinguishes between short-term and long-term capital gains. Long-term capital gains refer to profits from the sale of assets held for more than one year. These gains are subject to specific tax rates. Short-term capital gains, on the other hand, apply to assets held for one year or less and are taxed at different rates, typically aligned with your ordinary income tax bracket.

3. Tax Rates. The current long-term capital gains tax rates in the U.S. are 0%, 15%, or 20%, depending on the taxpayer’s income bracket for that tax year. Most taxpayers pay a lower rate on long-term capital gains compared to their ordinary income tax rate. This provides an incentive for investors to hold their investments for at least a year, as it can result in lower tax liability when realizing gains.

4. Higher Tax for Short-Term Gains. Short-term capital gains, which apply to assets held for less than a year, are taxed at a higher rate than long-term gains. This distinction can significantly impact the tax burden for day traders and individuals engaged in frequent online trading, as their gains are taxed at their ordinary income tax rate.

5. Offsetting Gains with Losses. Taxable capital gains for the year can be offset by the total capital losses incurred during the same year. In other words, your tax liability is calculated based on the net capital gain. There is a maximum allowable deduction of $3,000 per year for reported net losses. However, any remaining losses can be carried forward to offset gains in future tax years.

Long-Term Capital Gains Tax vs. Short-Term Capital Gains Tax

Capital gains taxes are divided into two major categories, short-term and long-term, and the distinction between them is based on how long you’ve held the asset. Here’s a breakdown of the differences between these two types of capital gains tax:

1. Short-Term Capital Gains Tax. Short-term capital gains tax is applicable to profits earned from the sale of an asset that you’ve held for less than a year. Short-term capital gains taxes are taxed at the same rate as your ordinary income, which includes sources like wages from a job, interest, and other regular income. Since short-term capital gains are taxed at ordinary income rates, they often result in a higher tax liability compared to long-term gains.

2. Long-Term Capital Gains Tax. Long-term capital gains tax applies to assets held for more than one year before being sold. The long-term capital gains tax rates are typically lower than the rates for ordinary income. These rates are set at 0 percent, 15 percent, or 20 percent, depending on your income and tax bracket. The advantage of long-term capital gains is that they are subject to reduced tax rates, making them a more tax-efficient option for investors who hold assets for extended periods.

Capital Gains Tax Rules and Considerations

Capital gains tax rules and considerations play a significant role in how investments are taxed, and understanding these rules is crucial for effective financial planning. Here’s an overview of key capital gains tax rules and considerations:

1. Holding Period Requirement. Capital gains taxes are typically applicable to profits generated from the sale of most investments, but only if the investments have been held for at least one year. The holding period requirement differentiates between short-term and long-term capital gains, with long-term gains often receiving more favorable tax treatment.

2. Reporting and Schedule D. To report capital gains taxes, taxpayers use a Schedule D form when filing their income tax return. This form allows individuals to detail the gains and losses from their investment activities.

3. Tax Rate Based on Income. The capital gains tax rate can be 0%, 15%, or 20%, depending on your taxable income for the tax year. High-income earners may face higher capital gains tax rates. It’s essential to consider the income levels, as they are adjusted annually for inflation.

4. Collectible Assets. Capital gains tax rates mentioned earlier apply to most assets, but there are exceptions. Long-term capital gains on "collectible assets" can be taxed at a maximum rate of 28%. Collectible assets include items such as coins, precious metals, antiques, and fine art. Short-term gains on these assets are typically taxed at the ordinary income tax rate.

5. Net Investment Income Tax. Some investors may be subject to an additional 3.8% tax known as the net investment income tax. This tax is applied to either your net investment income or the amount by which your modified adjusted gross income exceeds specific thresholds. The income thresholds that determine whether investors are subject to this tax are as follows: $200,000 for a single or head of household; $250,000 for married, filing jointly; $125,000 for married, filing separately; $250,000 for qualifying widow(er) with dependent child.

Example of Capital Gains

Meet Jeff, an investor who purchased 100 shares of Amazon (AMZN) stock on January 30, 2016, at a price of $350 per share. He then decides to sell all these shares on January 30, 2018, at a price of $833 each. Assuming there were no fees associated with the sale, let’s calculate Jeff’s capital gain:

Original Purchase Price per Share: $350 Selling Price per Share: $833 Number of Shares Sold: 100 Capital Gain = (Selling Price per Share - Original Purchase Price per Share) x Number of Shares Sold Capital Gain = ($833 - $350) x 100 = $48,300

Jeff’s capital gain from this transaction amounts to $48,300.

Now, let’s determine how the capital gains tax applies to Jeff’s situation. Jeff’s annual income is $80,000, which places him in the higher income group eligible for the long-term capital gains tax rate of 15%.

To calculate the tax on his capital gain, we use the following formula:

Capital Gains Tax = Capital Gain x Long-Term Capital Gains Tax Rate Capital Gains Tax = $48,300 x 0.15 = $7,245

Jeff should pay $7,245 in capital gains tax for this transaction. This amount is based on the 15% long-term capital gains tax rate that applies to his income bracket.