Capital Gains Treatment

What Is Capital Gains Treatment?

Capital gains treatments are specific taxes assessed on investment capital gains as determined by the tax code. When a stock is sold for a profit, the portion of the proceeds over and above the purchase value (or cost basis) is known as capital gains.

Key Takeaways

  • "Treatment" refers to the amount of time you must own a stock in order for it to be treated as either a short-term or a long-term investment.
  • Investments held for less than one year are considered short-term, while investments held for longer than one year are considered long-term.
  • Short-term investments are taxed at ordinary income rates, while long-term investments receive a lower capital gains rate of 0%, 15%, or 20%, depending on your income level.

Capital gains tax is broken down into two categories: short-term and long-term. Stocks held longer than one year are considered as long-term for the treatment of any capital gains, and are taxed at rates of 0%, 15%, or 20% depending on the investor's taxable income. Stocks held less than one year are considered short-term capital gains and are taxed at ordinary income rates, which range from 10% to 37% depending on the investor's tax bracket.

Understanding Capital Gains Treatment

The significant difference between the short-term and long-term rates makes it clear that paying close attention to the tax consequences of investing in stocks is a critical skill to develop.

As an investor's portfolio grows, the investor must keep a close eye on capital gains, including making adjustments near the end of the calendar year to reduce capital gains taxes as much as possible. The strategy of selling unprofitable stocks at a loss to offset gains in other sales is called tax-loss harvesting, and an accountant or investment professional can assist you in these efforts.

In recent years, discount brokers like Charles Schwab have added features to their desktop and mobile apps that show you where your gains and losses are. This helps do-it-yourselfers to harvest their tax losses without having to pay a professional to manage your portfolio. Robo-advisors such as Betterment also offer tax-loss-harvesting as a basic feature of your portfolio, though you don't have as much control over where they are investing your money.

How the Holding Period Affects Capital Gains Treatment

The holding period for a stockor the time frame during which the stock is ownedtypically begins from the day the stock is held by the investor, regardless of how long any warrants or options await to be exercised.

In many instances, the stock must be held at least one year and a day in order to receive the preferred long-term capital gains treatment. There are times, however, such as if the stock is expected to decline deeply, where it can be more advantageous to investors to sell those shares and pay the higher capital gains tax rate rather than face even deeper losses.

These days calculating the difference in your tax burden at different prices is quick and often automated, and if the stock price falls very far, you may not have to pay gains at all because you're already selling at a loss.

Real-World Examples of Capital Gains Treatment

There are cases where the holding period to receive long-term rates follow different rules. For example, if an individual were to inherit stock or another asset, they would automatically receive the preferred long-term rate.

If an employee is granted an incentive stock option, they must wait at least two years from the date the options were issued and at least one year from when the option was exercised and the stock came into the employee's possession.

When stock is gifted to another person, the time the shares spent in the possession of the person granting the stock would be included in the overall holding period.

Article Sources

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  1. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed Dec. 5, 2020.

  2. Internal Revenue Service. "IRS provides tax inflation adjustments for tax year 2020." Accessed Dec. 5, 2020.

  3. Ameriprise Financial. “Taxation of investments.”  Accessed Aug. 17, 2021.

  4. Charles Schwab. "Schwab Trading Services." Accessed Dec. 5, 2020.

  5. Betterment. "Experience the Next Generation of Tax Loss Harvesting." Accessed Dec. 5, 2020.

  6. Internal Revenue Service. "Publication 559: Survivors, Executors, and Administrators." Accessed Dec. 5, 2020.

  7. Internal Revenue Service. "Publication 525: Taxable and Nontaxable Income." Accessed Dec. 5, 2020.

  8. Internal Revenue Service. "Publication 544: Sales and Other Dispositions of Assets." Accessed Dec. 5, 2020.

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