The conceptual difference between income tax and capital gains tax is that income tax is the tax paid on income earned from interest, wages and rent, while capital gains tax is the tax paid on the sale or exchange of an asset such as a stock or property that is categorized as a capital asset.
A person's actual income tax percentage is variable based on his specific tax bracket, which is dependent on how much income he makes throughout the calendar year. Tax brackets are also variable based on whether a person files as an individual or jointly with a spouse. For 2019, the income tax percentages are between 10% and 37% of a person's yearly income, depending on how much he actually takes home as earnings.
Capital gains tax is categorized as short-term capital gains tax or long-term capital gains tax. While capital gains tax is applied to any sale or exchange of an asset, the time in which the asset was held by the seller determines if he is taxed at the short-term rate or the long-term rate.
If a seller has held an asset for longer than one year, he needs to pay taxes at the long-term capital gains rate, which depends on income and which is 0%, 15% or 20% for 2019. This means that if he is in a high-income bracket, whatever profit he made in the sale above the original purchase price, he has to pay 20% of that in taxes. If a seller has held an asset for less than one year, he needs to pay taxes at the short-term capital gains rate, which is the ordinary income tax rate of the seller based on his yearly income. If he is in the highest or 37% tax bracket, this means that whatever profit he made in the sale above the original purchase price, he has to pay 37% of that in taxes.
The Advisor Insight
The IRS separates taxable income into two main categories: "ordinary income" and "realized capital gain.” Ordinary income includes earned wages, rental income and interest income on loans, CDs and bonds (except for municipal bonds). A realized capital gain is the money from the sale of a capital asset (stock, real estate) at a price higher than the one you paid for it. If your asset goes up in price but you do not sell it, you have not "realized" your capital gain and therefore owe no tax.
The most important thing to understand is that long-term realized capital gains are subject to a substantially lower tax rate than ordinary income. So investors have a big incentive to hold appreciated assets for at least a year and a day, qualifying them as long-term and for the preferential rate.
Donald P. Gould
Gould Asset Management