What are capital gains?
Capital gains are the profits you earn between the time you purchase an investment and the time you sell it. The purpose of investing is to grow your wealth, and therefore it’s to be expected that there will be certain tax implications when it comes to the revenue you gain from your investments over time.
Capital Gains = Sale Price – Purchase Price
As an investor, it’s important to understand how capital gains are taxed so that you can make strategic decisions when it comes to how long you hold onto capital assets, like stock, before selling it. Current tax legislation in the U.S. incentivizes long-term investing by providing investors with a substantially lower tax obligation if they hold onto their investments for a year or more. On the other hand, short-term investing is subject to the same tax rate as your regular income.
Long-term capital gains
The realized revenue you earn on an asset that had been owned for 12 months or more is called long-term capital gains. If you were to sell this asset one year or more after the time of purchase, the long-term capital gains taxes would apply. Long-term capital gains taxes are more favorable than short-term capital gains taxes because they are almost certain to be taxed at a lower rate.
As of Jan. 2020, long-term capital gains taxes can range from 0% to 20% based on your tax bracket and filing status. The calculator on this page is designed to help you estimate your projected long-term capital gains tax obligation based on the income made from your assets as well as the nuances of your financial circumstances.
Short-term capital gains
Short-term capital gains occur when you earn revenue on an asset that has been sold within a year of ownership. This income is likely to be taxed at a higher rate since your standard income tax rate would apply. Of the seven existing tax brackets in the U.S., five are higher than the 20% maximum rate for long-term capital gains.
For some investors, the sale price of an asset might be less than the amount of money you paid for it, reflecting a capital loss. In these cases, a capital loss deduction may apply. If you are eligible, a capital loss deduction can offset income earned during the year.
Currently, taxpayers can deduct up to $3,000 worth of capital losses from their income. If your capital losses exceed this amount, you can apply the remaining deductions forward to future years.
Just as tax laws differentiate between long- and short-term capital gains, the same is true for losses. When calculating your overall deltas for long and short-term investments, consider both gains and losses. If your overall net result is a profit, then the capital gains rules above apply. If for one or either you have a loss, then you might be eligible to deduct $3,000 from your taxable income for the year.
History of capital gains tax
The first capital gains tax was introduced along with the first federal income tax legislation in 1913. Capital gains tax rates have fallen in recent years after peaking in the 1970s. Currently, the maximum capital gains rate is 20%.
Proponents of maintaining a relatively low capital gains tax rate argue that lower rates make investing more accessible to more people and stimulate economic growth. Those who believe the rates should be higher argue that low capital gains tax rates provide a loophole through which wealthy individuals can evade paying their fair share of taxes.
Understanding the difference between long- and short-term capital gains, and the tax implications for each, is an important exercise for investors. This knowledge is not only useful during tax season; it may also inform your decisions to hold on to or sell stock at certain intervals. Remember that the tax implications will vary by individual, and are tied to your overall financial circumstances.
The above content is provided is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.