Capital Gains

Capital Gains

A capital gain is the profit you earn when you sell a capital asset for more than you originally paid for it. This type of income is treated differently from regular wages or salary under the U.S. tax code, and understanding how it works can help you make sense of your tax bill when you sell investments, property, or other valuable assets.

How It Works

When you sell an asset, the IRS generally looks at two numbers: the cost basis (typically what you originally paid for the asset, including certain fees or improvements) and the sale price (what you received when you sold it). The difference between those two numbers is your capital gain, or in some cases, your capital loss.

Capital gains are typically divided into two categories based on how long you held the asset before selling:

• Short-term capital gains: Profits from assets held for one year or less. These are generally taxed at your ordinary income tax rate, the same rate that applies to your wages.
• Long-term capital gains: Profits from assets held for more than one year. These are typically taxed at lower, preferential rates of 0%, 15%, or 20%, depending on your total taxable income and filing status.

The holding period begins the day after you acquire the asset and ends on the day you sell it. This distinction matters quite a bit, because holding an asset just a little longer can sometimes move a gain from the short-term category to the long-term category, potentially reducing the taxes owed on that profit.

Practical Examples

Example 1: Stock Sale

Suppose you purchase 50 shares of stock at $40 per share, for a total cost of $2,000. Fourteen months later, you sell all 50 shares at $70 per share, receiving $3,500. Your capital gain is $1,500 (the $3,500 sale price minus your $2,000 cost basis). Because you held the shares for more than one year, this is a long-term capital gain, typically taxed at 0%, 15%, or 20% depending on your income level.

Example 2: Short-Term Sale

Now suppose you bought those same shares and sold them just eight months later at the same $70 price. The gain is still $1,500, but because the holding period was less than one year, it is generally classified as a short-term capital gain. In this case, the profit would typically be added to your ordinary income and taxed at your regular marginal rate, which could be considerably higher than the long-term rate.

A Few Important Details

Capital gains taxes in most cases apply only when you actually sell an asset. Simply owning an investment that has increased in value does not trigger a tax event. That unrealized gain generally becomes taxable only at the point of sale.

Capital losses (when you sell an asset for less than you paid) can typically be used to offset capital gains, potentially reducing your overall tax liability. If your losses exceed your gains in a given year, you can generally deduct up to $3,000 of the remaining loss against ordinary income, and carry any additional losses forward to future tax years.

Certain assets and situations may be subject to special rules. Real estate sales, for example, involve additional considerations such as depreciation recapture. Collectibles are generally taxed at a maximum long-term rate of 28%, which is higher than the standard long-term rates that apply to most stock or fund investments.

Related Tax Concepts to Explore

Capital gains connect closely to several other areas of tax law. Readers may find it helpful to also review:

• Cost Basis: How the original value of an asset is calculated and adjusted over time
• Capital Losses and Loss Harvesting: How losses can offset gains and reduce taxable income
• Net Investment Income Tax (NIIT): An additional 3.8% tax that applies to certain investment income for higher earners
• 1099-B Form: The form brokers use to report sales of securities to the IRS and to taxpayers
• Wash Sale Rule: A rule that limits your ability to claim a loss if you repurchase a substantially identical asset shortly after selling it