What Is a Capital Gain?
The term capital gain refers to the increase in the value of a capital asset when it is sold Put simply, a capital gain occurs when you sell an asset for more than what you originally paid for it. Almost any type of asset you own is a capital asset whether that's a type of investment (like a stock, bond, or real estate) or something purchased for personal use (like furniture or a boat). Capital gains are realized when you sell an asset by taking the subtracting the original purchase price from the sale price. The Internal Revenue Service (IRS) taxes individuals on capital gains in certain circumstances.
- A capital gain is the increase in a capital asset's value and is realized when the asset is sold.
- Capital gains apply to any type of asset, including investments and those purchased for personal use.
- The gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.
- Unrealized gains and losses reflect an increase or decrease in an investment's value but are not considered a taxable capital gain.
- A capital loss is incurred when there is a decrease in the capital asset value compared to an asset's purchase price.
Understanding Capital Gains
As noted above, capital gains represent the increase in the value of an asset. These gains are typically realized at the time that the asset is sold. Capital gains are generally associated with investments, such as stocks and funds, due to their inherent price volatility. But they can also be realized on any security or possession that is sold for a price higher than the original purchase price, such as a home, furniture, or a vehicle.
Capital gains fall into two categories:
- Short-term capital gains are those realized on assets that you've sold after holding them for one year or less
- Long-term capital gains are realized on assets that you've sold after holding them for more than one year
Both short- and long-term gains must be claimed on your annual tax return. Understanding this distinction and factoring it into investment strategy is particularly important for day traders and others who take advantage of the greater ease of trading in the market online.
Realized capital gains occur when an asset is sold, which triggers a taxable event. Unrealized gains, sometimes referred to as paper gains and losses, reflect an increase or decrease in an investment's value but are not considered a capital gain that should be treated as a taxable event. The tax rates for capital gains are listed below.
A capital loss is the opposite of a capital gain. It is incurred when there is a decrease in the capital asset value compared to an asset's purchase price.
Short- and long-term capital gains are taxed differently. Remember, short-term gains occur on assets held for one year or less. As such, these gains are taxed as ordinary income based on the individual's tax filing status and adjusted gross income (AGI).
Long-term capital gains, on the other hand, are taxed at a lower rate than regular income. The majority of individuals are taxed 15% on long-term capital gains, as long as their income falls below:
- $441,450 for a single filer
- $248,300 for married couples filing separately
- $469,050 for the head of a household
- $496,600 for married couples filing jointly
Individuals whose incomes are above these thresholds and are in a higher tax bracket are taxed 20% on long-term capital gains. Those who earn $40,000 or less ($80,000 or less for those married filing jointly) pay 0% on long-term capital gains.
Capital Gains and Mutual Funds
Shareholders receive the fund's capital gains distribution and get a 1099-DIV form outlining the amount of the gain and the type—short- or long-term. When a mutual fund makes a capital gain or dividend distribution, the net asset value (NAV) drops by the amount of the distribution. A capital gains distribution does not impact the fund's total return.
Tax-conscious mutual fund investors should determine a mutual fund's unrealized accumulated capital gains, which are expressed as a percentage of its net assets, before investing in a fund with a significant unrealized capital gain component. This circumstance is referred to as a fund's capital gains exposure. When distributed by a fund, capital gains are a taxable obligation for the fund's investors.
Example of Capital Gains
Here's a hypothetical example to show how capital gains work and how they're taxed. Let's say Jeff purchased 100 shares of Amazon (AMZN) stock on Jan. 30, 2016, at $350 per share. He then decides to sell all the shares on Jan. 30, 2018, at a price of $833 each. Assuming there were no fees associated with the sale, Jeff realized a capital gain of $48,300 ($833 x 100 - $350 x 100 = $48,300).
Jeff earns $80,000 per year, which puts him in the enormous income group ($40,001 to $441,500 for individuals and $80,001 to $496,600 for those married filing jointly) that qualifies for long-term capital gains tax rate of 15%.
Jeff should, therefore, pay $7,245 in tax ($48,300 x 0.15 = $7,245) for this transaction.
How Are Capital Gains Taxed?
Capital gains are classified as either short-term or long-term. Short-term capital gains, defined as gains realized in securities held for one year or less, are taxed as ordinary income based on the individual's tax filing status and adjusted gross income. Long-term capital gains, defined as gains realized in securities held for more than one year, are usually taxed at a lower rate than regular income.
What Are the Current Capital Gains Tax Rates in the U.S.?
The long-term capital gains rate is 20% for individuals who make more than $441,451 and for married couples filing jointly who earn more than $496,601.
Most taxpayers, though, qualify for a 15% long-term capital gains tax rate as long as they earn $40,001 to $441,450 for single filers and $80,001 to $496,600 for married couples filing jointly.
Taxpayers who make up to $40,000 ($80,000 for those married filing jointly) could pay nothing (0%) in the long-term capital gains.
Short-term capital gains tax rates match the ordinary income tax brackets (10% to 37%).
How Do Mutual Funds Account for Capital Gains?
Mutual funds that accumulate realized capital gains must distribute them to shareholders and often do so right before the end of the calendar year. Shareholders receive the fund's capital gains distribution along with a 1099-DIV form detailing the amount of the capital gain distribution and how much is considered short-term and long-term. This distribution reduces the mutual fund's net asset value by the amount of the payout though it does not impact the fund's total return.
What Is a Net Capital Gain?
The IRS defines a net capital gain as the amount by which net long-term capital gain (long-term capital gains minus long-term capital losses and any unused capital losses carried over from prior years) exceeds net short-term capital loss (short-term capital gain minus short-term capital loss). A net capital gain may be subject to a lower tax rate than the ordinary income tax rate.