What Are Capital Gains?

The capital gains tax is the tax you pay on the profits from the sale of assets you have owned for at least one year. Capital gains are included in your taxable income but are generally taxed at a lower rate than regular income to encourage long-term investment in the U.S. economy.

The profits from selling assets not owned for the one-year holding period are known as short-term capital gains. There is no short-term capital gains tax, so the Internal Revenue Service (IRS) includes profits from the sale of assets held for less than a year in your gross income for income tax purposes.

For high-income taxpayers, ordinary income is taxed at a higher rate than capital gains, so it is generally to their benefit to get as much income as possible classified as capital gains. To help do that, tax advisors often encourage clients to hold assets for longer than one year before selling to reduce their tax bills.

Key Takeaways

• You only pay the capital gains tax on profits from the sale of assets you have owned for more than one year.
• For individuals in the higher income tax brackets, the tax rate on capital gains is often less than the income tax rate for other types of earnings.
• When you lose money on the sale of a capital asset, you can use that loss to cancel out the gain you received on the sale of a different investment and reduce the amount of gain subject to tax.

What Is the Capital Gains Tax?

The investment income from the sale of assets you have held for more than one year is a capital gain subject to the capital gains tax. These assets are often called "capital assets," and the profits you earn from their sale are considered net capital gains. These assets may include:

• Stocks, including small-business stocks not purchased through a brokerage
• Bonds
• Businesses
• Real estate
• Cars and boats
• Mutual funds

Some long-term assets receive beneficial tax treatment from the IRS. For example, although they are classified as real property, a portion of the profit from home sales is tax-free. That means the first $500,000 of profits from the sale of a married couple's principal residence ($250,000 for individual filers) benefits from an exemption from the capital gains tax if the couple has lived there for two years or more.

Additionally, any gains from the sale of collectibles are taxed at a 28% rate. Finally, if you have taken tax deductions for the depreciation of investment real estate, the taxable gain is increased by the amount of the claimed deductions when you sell the property.

Retirement Accounts

Tax-advantaged retirement accounts like IRAs and 401(k)s are usually not considered capital assets, and distributions from those accounts are taxed as ordinary income.

What Are Capital Losses?

When the sale price of a capital asset is less than its purchase price, the amount lost on the transaction is treated as a capital loss on your federal income tax return. You can use that loss to offset your gains from the sale of other capital assets to help reduce the amount of capital gains tax you pay. Thus, if you sell some of your stock for $500 less than you paid for it and sell other stock for a $1,000 profit, the loss would be subtracted from the profit, and you would only pay the capital gains tax on $500 of your $1,000 in profits.

When you have more capital losses in a tax year than capital gains, you can still use that loss to decrease your taxable profits in a future tax year. This carrying forward of the capital loss lets you reduce the capital gains tax due in future years.

What is the Capital Gains Tax Rate?

Long-term capital gains tax rates are 0%, 15%, or 20%, depending on how much capital gain you have realized during the tax year. The chart below shows the 2023 thresholds based on the taxpayer's filing status:

State Capital Gains Taxes

Forty-three states have their own versions of the capital gains tax. The state tax rates range from 13.3% in California to 2.5% in Arizona.

Additional Questions? Contact a Tax Lawyer

If you have sold assets or are thinking of selling assets in the future, a local tax attorney can help you assess the impact of the capital gains tax. While the underlying concept is straightforward, determining how to structure the sale of long-term assets to maximize your financial gain can quickly become complex. An experienced tax attorney understands the tax implications of investment transactions and can help structure the deal to minimize the amount of tax you will owe. Additionally, a tax lawyer can help with tax planning to reduce the tax you will need to pay in future years.