What Is a Capital Gain?
A capital gain refers to the increase in the value of a capital asset when it is sold. Put simply, a capital gain occurs when you sell an asset for more than what you originally paid for it.
Almost any type of asset you own is a capital asset. This can include a type of investment (like a stock, bond, or real estate) or something purchased for personal use (like furniture or a boat).
Capital gains are realized when you sell an asset by subtracting the original purchase price from the sale price. The Internal Revenue Service (IRS) taxes individuals on capital gains in certain circ*mstances.
Key Takeaways
- A capital gain is the increase in a capital asset's value and is realized when the asset is sold.
- Capital gains may apply to any type of asset, including investments and those purchased for personal use.
- The gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.
- Unrealized gains and losses reflect an increase or decrease in an investment's value but are not considered a taxable capital gain.
- A capital loss is incurred when there is a decrease in the capital asset value compared to an asset's purchase price.
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Understanding Capital Gains
As noted above, capital gains represent the increase in the value of an asset. These gains are typically realized at the time that the asset is sold. Capital gains are generally associated with investments, such as stocks and funds, due to their inherent price volatility. But they can also be realized on any security or possession that is sold for a price higher than the original purchase price, such as a home, furniture, or vehicle.
Capital gains fall into two categories:
- Short-term capital gains: Gains realized on assets that you've sold after holding them for one year or less
- Long-term capital gains: Gains realized on assets that you've sold after holding them for more than one year
Both short- and long-term gains must be claimed on your annual tax return. Understanding this distinction and factoring it into investment strategy is particularly important for day traders and others who take advantage of the greater ease of trading in the market online.
Realized capital gains occur when an asset is sold, which triggers a taxable event. Unrealized gains, sometimes referred to as paper gains and losses, reflect an increase or decrease in an investment's value but are not considered a capital gain that should be treated as a taxable event. For example, if you own stock that goes up in price, but you haven't yet sold it, that is an unrealized capital gain.
The tax rates for capital gains are listed below.
A capital loss is the opposite of a capital gain. It is incurred when there is a decrease in the capital asset value compared to an asset's purchase price.
Capital Gains Tax
Short- and long-term capital gains are taxed differently. Tax-efficient investing can lessen the impact of these taxes. Remember, short-term gains occur on assets held for one year or less. As such, these gains are taxed as ordinary income based on the individual's tax filing status and adjusted gross income (AGI).
Long-term capital gains, on the other hand, are taxed at a lower rate than regular income. The exact rate depends on the filer's income and marital status, as shown below:
| Long Term Capital Gains Tax Rates for 2022 and 2023 | |||
|---|---|---|---|
| Filing Status | Taxed at0% | Taxed at 15% | Taxed at20% |
| Single | Up to $40,400 | $40,401 — $445,850 | $445,851 and above |
| Married filing jointly | Up to $80,800 | $80,801 —$501,600 | $501,601 and above |
| Married filing separately | Up to $40,400 | $40,401—$250,800 | $250,801 and above |
| Head of Household | Up to $54,400 | $54,401—$473,750 | $473,751 and above |
Special Capital Gains Tax Rules
Note that there are some caveats. Certain types of stock or collectibles may be taxed at a higher 28% capital gains rate, and real estate gains can go as high as 25%. Moreover, if the capital gains put your income over the threshold for the 15% capital gains rate, the excess will be taxed at the higher 20% rate.
In addition, certain types of capital losses are not deductible. If you sell your house or car at a loss, you will be unable to deduct the difference on your taxes. However, when you sell your primary home, the first $250,000 is exempt from capital gains tax. That figure doubles to $500,000 for married couples.
Individuals whose incomes are above these thresholds and are in a higher tax bracket are taxed 20% on long-term capital gains. High-net-worth investors may have to pay the additional net investment income tax, on top of the 20% they already pay for capital gains.
Assets Eligible for Capital Gains
Not all investments are eligible for the lower capital gains rates. The following are some assets that are and are not eligible.
| Eligibility of Certain Assets for Capital Gains Tax Treatment | |
|---|---|
| Eligible Assets | Not Eligible |
| Stocks | Business inventory |
| Bonds | Depreciable business property |
| Jewelry | Real estate used by your business or as a rental property |
| Cryptocurrency (including NFTs) | Copyrights, Patents, and Inventions |
| Homes and Household furnishings | Literary or Artistic Compositions |
| Vehicles | |
| Collectibles | |
| Timber | |
| Fine artworks | |
Capital Gains and Mutual Funds
Mutual funds that accumulate realized capital gains throughout the tax year must distribute these gains to shareholders. Many mutual funds distribute capital gains right before the end of the calendar year.
Shareholders receive the fund's capital gains distribution and get a 1099-DIV form outlining the amount of the gain and the type: short- or long-term. Undistributed long-term capital gains are reported to shareholders on Form 2439. When a mutual fund makes a capital gain or dividend distribution, the net asset value (NAV) drops by the amount of the distribution. A capital gains distribution does not impact the fund's total return.
Tax-conscious mutual fund investors should determine a mutual fund's unrealized accumulated capital gains, which are expressed as a percentage of its net assets, before investing in a fund with a significant unrealized capital gain component. This circ*mstance is referred to as a fund's capital gains exposure. When distributed by a fund, capital gains are a taxable obligation for the fund's investors.
Example of Capital Gains
Here's a hypothetical example to show how capital gains work and how they're taxed. Let's sayJeff purchased 100 shares of Amazon (AMZN) stock on Jan. 30, 2016, at $350 per share. He then decides to sell all theshares on Jan. 30, 2018, at a price of $833 each. Assuming there were no fees associated with the sale, Jeff realized a capital gain of $48,300 ($833 x 100 - $350 x 100 = $48,300).
Jeff earns $80,000 per year, which puts him in the enormousincome group ($40,001to $441,500 for individuals and $80,001to $496,600 for those married filing jointly) that qualifies for long-term capital gains tax rate of15%.
Jeffshould, therefore, pay $7,245 in tax ($48,300 x 0.15 = $7,245) for this transaction.
How Are Capital Gains Taxed?
Capital gains are classified as either short-term or long-term. Short-term capital gains, defined as gains realized in securities held for one year or less, are taxed as ordinary income based on the individual's tax filing status and adjusted gross income. Long-term capital gains, defined as gains realized in securities held for more than one year, are usually taxed at a lower rate than regular income.
What Is the 2023 Capital Gains Tax Rate?
In 2023, long-term capital gains can be taxed at 0%, 15%, 20%, or 25%. The rate at which your gains are taxed will depend on your income, filing status, and the type of asset. Short-term capital gains are taxed at your ordinary income tax rate.
How Do Mutual Funds Account for Capital Gains?
Mutual funds that accumulate realized capital gainsmust distribute the gains to shareholders and often do so right before the end of the calendar year. Shareholders receive the fund's capital gains distribution along with a 1099-DIV form detailing the amount of the capital gain distribution and how much is considered short-term and long-term. This distribution reduces the mutual fund's net asset value by the amount of the payout though it does not impact the fund's total return.
What Is a Net Capital Gain?
The IRS defines a net capital gain as the amount by which net long-term capital gain (long-term capital gains minus long-term capital losses and any unused capital losses carried over from prior years) exceeds net short-term capital loss (short-term capital gain minus short-term capital loss). A net capital gain may be subject to a lower tax rate than the ordinary income tax rate.
How Do I Avoid Capital Gains Tax on My House?
You can reduce capital gains tax on your home by living in it for more than two years and keeping the receipts for any home improvements you make. The cost of these improvements can be added to the cost basis of your house and reduce the overall gain that will be taxed.
The Bottom Line
Capital gains are the profits that are realized by selling an investment, such as stocks, bonds, or real estate. Capital gains taxes are lower than ordinary income taxes, providing an advantage to investors over wage workers. Moreover, capital losses can sometimes be deducted from one's total tax bill.
For these reasons, a thorough understanding of capital gains taxes can make a big difference for an investor.
Article Sources
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Internal Revenue Service. "Topic No. 409 Capital Gains and Losses."
Internal Revenue Service. "Topic No. 409: Capital Gains and Losses."
U.S. Securities and Exchange Commission. "Mutual Funds and ETFs," Pages 36-37.
Internal Revenue Service. "Mutual Funds (Costs, Distributions, Etc.)."
Internal Revenue Service. "Publication 550: Investment Income and Expenses," Page 18.
