What is Capital Gain?
Capital gain is an increase in a capital asset's value. It is considered to be realized when you sell the asset. A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes. Understanding this distinction and factoring it into investment strategy is particularly important for day traders and others taking advantage of the greater ease of trading in the market online.
Understanding Capital Gains
While capital gains are generally associated with stocks and funds due to their inherent price volatility, a capital gain can occur on any security that is sold for a price higher than the purchase price that was paid for it. Realized capital gains and losses occur when an asset is sold, which triggers a taxable event. Unrealized gains and losses, sometimes referred to as paper gains and losses, reflect an increase or decrease in an investment's value but have not yet triggered a taxable event.
A capital loss is incurred when there is a decrease in the capital asset value compared to an asset's purchase price.
Tax Consequences of Capital Gains and Losses
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.
Short-term capital gains occur on securities held for one year or less. These gains are taxed as ordinary income based on the individual's tax filing status and adjusted gross income. Long-term capital gains are usually taxed at a lower rate than regular income. The long-term capital gains rate is 20% in the highest tax bracket. Most taxpayers qualify for a 15% long-term capital gains tax rate. However, taxpayers earning up to $40,000 ($80,000 for those married filing jointly) would pay a 0% long-term capital gains tax rate for tax year 2020.
For example, say Jeff purchased 100 shares of Amazon stock on January 30, 2016, at $350 per share. Four years later, on January 30, 2018, he sells all the shares at a price of $833 each. Assuming there were no fees associated with the sale, Jeff realized a capital gain of $48,300 ($833 * 100 - $350 * 100 = $48,300). Jeff earns $80,000 per year, which puts him in the enormous income group ($40,001 to $441,500 for individuals; $80,001 to $496,600 for those married filing jointly) that qualifies for 2020 long-term capital gains tax rate of 15%. Jeff should, therefore, pay $7,245 in tax ($48,300 * .15 = $7,245) for this transaction.
Capital Gains Distributions by Mutual Funds
Mutual funds that have accumulated realized capital gains throughout the course of the year must distribute those gains to shareholders. Many mutual funds distribute capital gains right before the end of the calendar year.
Shareholders of record as of the fund's ex-dividend date receive the fund's capital gains distribution. Individuals receiving the distribution get a 1099-DIV form detailing the amount of the capital gain distribution and how much is considered short-term and 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.