Interest-bearing investments differ in the way they produce returns for their owners. When an investor sells an investment for more than he or she originally purchased it for, the difference between those values is known as the capital gain. When you buy a stock for $1,000 and subsequently sell it for $1,200, you realize a capital gain of $200. However, you may have also received periodic interest payments from the stock's issuing company while you owned it. These interest payments are called dividends, and the treatment of dividend returns is very different than the treatment of capitals gains.
Dividends and capital gains are the two wealth-building tools of the stock market; investments either rise in price through capital appreciation, or companies pay out a portion of their own profits to shareholders as dividends. Market shorthand for unrealized capital gains, meaning the asset has not yet been sold, is the "return," while the shorthand for dividends is the "yield."
Strictly speaking, dividends are not actually interest payments, because dividends actually damage stock prices slightly after they are distributed. However, the stockholder receives that income immediately. Capital gains only result from the sale of an investment; when a stock's price rises from $100 to $105, you only really gained the ability to sell for a 5% capital gain. If the price falls again to $98 before you sell, you do not realize that 5% gain.
The tax rules for dividends and capital gains change frequently, but the IRS addresses each type of return differently. In fact, long-term capital gains, or assets held longer than one year, are treated differently than short-term capital gains. Short-term gains are often taxed similarly to dividend income.
The Advisor Insight
A capital gain (or loss) is the difference between your purchase price and the value of the security when you sell it. A dividend is a payout to shareholders from the profits of a company that is authorized and declared by the board of directors.
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