When you sell a capital asset for more than you paid for it, the result is a capital gain. Capital assets include stocks, bonds, precious metals, jewelry, and real estate. The tax you'll pay on the capital gain depends on how long you held the asset before selling it. Capital gains are classified as either long-term or short-term and are taxed accordingly.
It's important to keep these taxes in mind whenever you sell an asset, especially if you have been dabbling in day trading online. First off, any profits you make are taxable. And second, you may have heard that capital gains are taxed more favorably than other types of income, but that's not always the case. As mentioned above, it depends on how long you owned those assets before you sold them.
Long-term capital gains are derived from assets that are held for more than one year before they are disposed of. Long-term capital gains are taxed according to graduated thresholds for taxable income at 0%, 15%, or 20%. The tax rate on most taxpayers who report long-term capital gains is 15% or lower.
Short-term capital gains are taxed just like your ordinary income. That's up to 37% depending on your tax bracket.
- Selling a capital asset—for example, stocks, bonds, precious metals, or real estate—for more than the purchase price results in a capital gain.
- Short-term capital gains result from selling capital assets owned for one year or less and are taxed as regular income.
- Long-term capital gains result from selling capital assets owned for more than one year and are subject to tax of 0%, 15%, or 20%.
The Difference Between Short-Term and Long-Term
A short-term capital gain results from the sale of an asset owned for one year or less. While long-term capital gains are generally taxed at a more favorable rate than salary or wages, gains that are classified as short-term do not benefit from any special tax rates. They are subject to taxation as ordinary income.
Net capital gains are calculated based on your adjusted basis in an asset. That is the amount you paid to acquire the asset, less depreciation, plus any costs you incurred during the sale of the asset and the costs of any improvements you made. If an asset is given to you as a gift, you inherit the donor's basis.
The tax on a long-term capital gain is almost always lower than if the same asset were sold (and the gain realized) in less than a year. Because long-term capital gains are generally taxed at a more favorable rate than short-term capital gains, you can minimize your capital gains tax by holding assets for a year or more.
Long-Term Capital Gains Tax Rates
After the passage of the Tax Cuts and Jobs Act (TCJA), the tax treatment of long-term capital gains changed. Prior to 2018, the tax brackets for long-term capital gains were closely aligned with income tax brackets. TCJA created unique tax brackets for long-term capital gains tax. These numbers generally change from year to year.
|Tax Rates for Long-Term Capital Gains 2020|
Up to $40,000
$40,000 to to $441,450
Head of household
Up to $53,600
$53,600 to $469,050
Married filing jointly
Up to $80,000
$80,000 to $496,600
Married filing separately
Up to $40,000
$40,000 to $248,300
Source: Internal Revenue Service.
Short-Term Capital Gains Tax Rates
Short-term capital gains are taxed as though they are ordinary income. Any income you receive from investments you held for less than a year must be included in your taxable income for that year. For example, if you have $80,000 in taxable income from your salary and $10,000 from short-term investments, your total taxable income is $90,000.
The tax you'll pay on short-term capital gains follows the same tax brackets as ordinary income.
|Tax Rates for Short-Term Capital Gains 2020|
|Single||Up to $9,875||$9,876 to $40,125||$40,126 to $85,525||$85,526 to $163,300||$163,301 to $207,350||$207,351 to $518,400||Over $518,400|
|Head of household||Up to $14,100||$14,101 to $53,700||$53,701 to $85,500||$85,501 to $163,300||$163,301 to $207,350||$207,351 to $518,400||Over $518,400|
|Married filing jointly||Up to $19,750||$19,751 to $80,250||$80,251 to $171,050||$171, 051 to $326,600||$326,601 to $414,700||$414,701 to $622,050||Over $622,050|
|Married filing separately||Up to $9,875||$9,876 to $40,125||$40,126 to $85,525||$85,526 to $163,300||$163,301 to $207,350||$207,351 to $311,025||Over $311,025|
Source: Internal Revenue Service.
Ordinary income is taxed at differing rates depending on your income. It's possible that a short-term capital gain—or part of it at least—might be taxed at a higher rate than your regular earnings. That's because it might cause part of your overall income to jump into a higher tax bracket.
For example, using the 2020 federal income tax rates, and assuming you are filing that income as a single person, you'd be in the 22% tax bracket with your taxable income from your salary. However, because of the progressive nature of the federal tax system, the first $9,875 you earn would be taxed at 10%, your income from $9,876 up to $40,125 would be taxed at 12%, and only the income from $40,126 to $85,525 would be taxed at 22%.
Part of your $10,000 capital gain—the portion up to the $85,525 limit for the bracket—would be taxed at 22%. The remaining $4,475 of the gain, however, would be taxed at 24%, the rate for the next-highest tax bracket.
Capital Gains and State Taxes
Whether you have to pay capital gains to the state as well depends on where you live.
Some states also tax capital gains, while others have no capital gains taxes or favorable treatment of them.
The following states have no income taxes, and therefore no capital gains taxes: Alaska, Florida, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Colorado, Nevada, and New Mexico do not tax capital gains. Montana has a credit to offset part of any capital gains tax.
Capital Gains Special Rates and Exceptions
Some assets receive different capital-gains treatment or have different time frames than the rates indicated above.
You're taxed at a 28% rate—regardless of your income—for gains on art, antiques, jewelry, precious metals, stamp collections, coins, and other collectibles.
The tax treatment of a qualified small business stock depends on when the stock was acquired and how long it was held. In order to qualify for this exemption, the stock must have been acquired from a qualified small business after Aug. 10, 1993, and the investor must have held the stock for at least five years. This exclusion has a cap of $10 million, or 10 times the adjusted basis of the stock—whichever is greater. Any capital gains above that amount are subject to a 28% rate.
Owner-Occupied Real Estate
There's a special capital gains arrangement if you sell your principal residence. The first $250,000 of an individual's capital gains on the sale of your principal residence is excluded from taxable income ($500,000 for those married filing jointly) as long as the seller has owned and lived in the home for two of the five years leading up to the sale. If you sold your home for less than you paid for it, this loss is not considered tax-deductible, because capital losses from the sale of personal property, including your home, are not tax-deductible.
For example, a single taxpayer who purchased a house for $300,000 and later sells it for $700,000 made a $400,000 profit on the sale. After applying the $250,000 exemption, they must report a capital gain of $150,000. This is the amount subject to the capital gains tax.
In most cases, significant repairs and improvements can be added to the base cost of the house. These can serve to further reduce the amount of taxable capital gain. If you spent $50,000 to add a new kitchen to your home, this amount could be added to the $300,000 original purchase price. This would raise the total base cost for capital gains calculations to $350,000 and lower the taxable capital gain from $150,000 to $100,000.
Investment Real Estate
Investors who own real estate are often allowed to apply deductions to their total taxable income based on the depreciation of their real estate investments. This deduction is meant to reflect the steady deterioration of the property as it ages, and essentially reduces the amount you're considered to have paid for the property in the first place. This also has the effect of increasing your taxable capital gain when the property is sold.
For example, if you paid $200,000 for a building and you're allowed to claim $5,000 in depreciation, you'll be treated subsequently as if you'd paid $195,000 for the building. If you then sell the real estate, the $5,000 is treated as recapturing those depreciation deductions. The tax rate that applies to the recaptured amount is 25%.
So if you sold the building for $210,000, there would be total capital gains of $15,000. But $5,000 of that figure would be treated as a recapture of the deduction from income. That recaptured amount is taxed at 25%, where the remaining $10,000 of capital gain would be taxed at one of the 0%, 15%, or 20% rates indicated above.
High-income earners may be subject to another tax on their capital gains, called the net investment income tax. This tax imposes an additional 3.8% on your investment income, including your capital gains if your modified adjusted gross income (MAGI) exceeds certain maximums: $250,000 if married and filing jointly or you're a surviving spouse, $200,000 if you're single or a head of household, and $125,000 if married filing separately.
Advantages of Long-Term Capital Gains
It can be advantageous to keep investments for longer if they will be subject to capital gains tax once they're realized.
The tax rate will be lower for most people if they realize a capital gain in more than a year. For example, suppose you bought 100 shares of XYZ stock at $20 per share and sold them at $50 per share. Your regular income from earnings is $100,000 a year and you are part of a married couple that files jointly. The chart below compares the taxes you'd pay if you held and sold the stock in more than a year and less than a year.
|How Patience Can Pay Off in Lower Taxes|
|Transactions and consequences||Long-term capital gain||Short-term capital gain|
|Bought 100 shares @ $20||$2,000||$2,000|
|Sold 100 shares @ $50||$5,000||$5,000|
|Capital gain||$450 (taxed @ 15%)||$720 (taxed @24%)|
|Profit after tax||$2,550||$2,280|
This chart shows how a married couple earning $100,000 a year could avoid almost $300 in taxes by waiting at least a year before selling shares that had appreciated $3,000.
The sale of qualified small business stock is treated favorably for capital gains purposes. Under Section 1202 of the Internal Revenue Code—the Small Business Stock Gains Exclusion—the capital gains from qualified small businesses are exempt from federal taxes.
You would pay $450 of your profits by opting for a long investment gain and being taxed at long-term capital gains rates. But had you held the stock for less than one year (and so incurred a short-term capital gain), your profit would have been taxed at your ordinary income tax rate. For our $100,000 a year couple, that would trigger a tax rate of 24%, the applicable rate for income over $85,500 in 2020. That adds an additional $270 to the capital-gains tax bill, for a total of $720.
While it's possible to make a higher return by cashing in your investments frequently and repeatedly shifting the funds to fresh new investment opportunities, that higher return may not compensate for higher short-term capital gains tax bills. To illustrate, consider the 30-year impact of investing $1,000 for a high-income-earning couple who'd pay the highest long-term capital gains rate of 20%.
In this scenario, the calculations compared investing in a long-run strategy with a series of short-term investments that were held for less than a year.
The long-run strategy would yield almost an additional $20,000 over 30 years compared with the short-term approach. That holds true despite the long-term investment earning 10% a year versus 12% for each of the short-term investments.
Making constant changes in investment holdings, resulting in high payments of capital gains tax and commissions, is called churning.
The Bottom Line
The tax on a long-term capital gain is almost always lower than if the same asset were sold in less than a year; most taxpayers don't have to pay the highest long-term rate. Tax policy encourages you to hold assets subject to capital gains for a year or more.
Internal Revenue Service. "Publication 544: Sales and Other Dispositions of Assets." Accessed Jan. 5, 2021.
Internal Revenue Service. “Topic No. 409 Capital Gains and Losses.” Accessed Jan. 5, 2021.
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Internal Revenue Service. "Rev. Proc. 2019-44," Pages 5-7. Accessed Jan. 5, 2021.
Washington Policy Center. "Which States Don't Have a Capital Gains Income Tax." Accessed Jan. 31, 2021.
Government Printing Office. "Title 26, Internal Revenue Code, Section 1202," Page 2,017. Accessed Jan. 5, 2021.
Internal Revenue Service. "Topic No. 701 Sale of Your Home." Accessed Jan. 5, 2021.
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