Financial Terms / C - D / Capital gains

What are capital gains?

Capital gains are profits you make when you sell a capital asset for more than you paid. These assets can be almost anything you own for personal use or investment purposes. This includes your home, stocks, bonds, or even collectibles.

When you sell a capital asset, you calculate the gain by subtracting the original purchase price (plus any improvements) from the selling price. This difference is your capital gain. For example, if you buy ten shares of stock for $10 each and sell them for $15 each, your capital gain is $50.

Capital gains come in two types: short-term and long-term. Short-term gains happen when you sell an asset you've owned for one year or less. Long-term gains occur when you've held the asset for over a year.

It's important to know that capital gains only become "realized" when you sell the asset. Until then, any increase in value is just an "unrealized" or "paper" gain. For instance, if your stocks go up in value but you haven't sold them, that's an unrealized gain.

Understanding capital gains is crucial because they're subject to taxes. However, the tax rate can vary depending on whether the gain is short-term or long-term, and your overall income level.

Short-Term vs. Long-Term Capital Gains

Capital gains are split into two main groups: short-term and long-term. The difference lies in how long you've owned the asset.

Short-term capital gains come from selling assets you've held for a year or less. These gains are taxed at the same rate as your regular income, like your wages. The tax rates for short-term gains range from 10% to 37%, depending on your income bracket.

Long-term capital gains result from selling assets you've owned for more than a year. These gains often benefit from lower tax rates: 0%, 15%, or 20%, based on your income. For instance, in 2023, if you're a single filer with a taxable income of $44,625 or less, you won't pay any tax on long-term capital gains.

The holding period is key. To figure out how long you've owned an asset, count from the day after you bought it up to and including the day you sold it.

Remember, some exceptions exist. Collectibles like art or coins are taxed at 28%, regardless of how long you've owned them. Also, high-income earners might face an extra 3.8% Net Investment Income Tax on their gains.

How Capital Gains Are Taxed

Capital gains taxes apply to profits you make when selling assets like stocks, real estate, or investments. The tax rate depends on how long you've owned the asset.

Short-term capital gains come from assets held for a year or less. These are taxed at your ordinary income rate, which can be up to 37%. There's no special treatment for short-term gains.

Long-term capital gains are from assets held over a year. These get better tax rates: 0%, 15%, or 20%, based on your income. For example, in 2023, single filers with taxable income up to $44,625 pay 0% on long-term gains.

Some exceptions exist. Collectibles like art or coins face a 28% tax rate, regardless of holding time. High earners might also owe an extra 3.8% Net Investment Income Tax.

To lower your tax bill, consider holding investments longer than a year. This simple strategy can lead to significant tax savings, making long-term investing more attractive for many people.

Strategies to Minimize Capital Gains Tax

You can use several strategies to lower your capital gains tax burden. One effective method is tax-loss harvesting. This involves selling underperforming investments to book a loss. You can use these losses to offset taxable gains and up to $3,000 of ordinary income each year. Unused losses can be carried forward indefinitely.

Another strategy is to use tax-advantaged accounts like 401(k)s and IRAs. These accounts offer tax-deferred growth, meaning you don't pay taxes on gains until you withdraw the money. Roth accounts go a step further, allowing tax-free withdrawals in retirement if certain rules are followed.

Holding assets for over a year can also help. Long-term capital gains often have lower tax rates than short-term gains. If possible, try to hold onto taxable assets for at least a year.

Timing your sales is crucial too. Consider selling assets when your yearly income is lower, as this could put you in a lower tax bracket for capital gains.