What Are Capital Gains? Definition, Types & Tax Implications
Capital gains are only taxed once they are realized via the sale of an asset.
What Is a Capital Gain in Simple Terms?
A capital gain is a positive difference between what an asset was purchased for and what it is currently worth. In other words, it is the amount by which an asset has gone up in value since it was acquired.
For instance, if an investor bought a share of a company’s stock for $40 a year ago, but now it trades at $55, that $15 difference is the investor’s capital gain. If, on the other hand, this $40 investment went down in value to $25 over the last year, the investor would have experienced a capital loss of $15.
Stocks aren’t the only assets that can drive capital gains and losses, though—any asset, whether purchased as an investment (like a treasury bond or a call option) or for personal use (like a home or motor vehicle) can go up or down in value over time, resulting in capital gains or losses.
A capital gain represents a positive change in an asset’s value over time, but it is not considered income—or taxed—until it is realized. If an investor still owns an asset that has gone up in value, their capital gain is considered unrealized.
What Does It Mean When a Capital Gain Is Realized?
Capital gains are realized when they are “locked-in” via the sale of an asset that has appreciated in value since it was purchased.
For instance, if the investor in the example above sold their share of stock once it was worth $55, they would realize their capital gain of $15. If, on the other hand, they continued to hold the stock, their capital gain would remain unrealized, and the value of the stock would continue to change over time.
Once realized, a capital gain becomes a form of income, and for this reason, it is subject to taxes.
How Are Realized Capital Gains Calculated?
To calculate the realized capital gain on an asset, simply subtract its initial purchase price from the amount it was sold for.
Realized Capital Gain Formula
RCG = Sale Price – Purchase price
How Are Capital Gains Taxed?
As mentioned above, once realized, capital gains are subject to taxes. The rate at which they are taxed depends on two things—how long the asset in question was held before being sold, and how much taxable income the person who sold it made during the year when they sold the asset.
Short-Term Capital Gains
If an asset is held for less than one year before being sold, the resulting capital gain (or loss) is considered short-term. Short-term capital gains are taxed at the same rate as normal income. For the 2022 tax year, income tax rates vary between 10% and 37% depending on an individual’s tax bracket. See the table below for details.
2022 Short-Term Capital Gains Rates
| Rate | Single | Married/Joint | Married/Separate | Head of Household |
|---|---|---|---|---|
10% | $0 – $10,275 | $0 – $20,550 | $0 – $10,275 | $0 – $14,650 |
12% | $10,275 – $41,775 | $20,550 – $83,550 | $10,275 – $41,775 | $14,650 – $55,900 |
22% | $41,775 – $89,075 | $83,550 – $178,150 | $41,775 – $89,075 | $55,900 – $89,050 |
24% | $89,075 – $170,050 | $178,150 – $340,100 | $89,075 – $170,050 | $89,050 – $170,050 |
32% | $170,050 – $215,950 | $340,100 – $431,900 | $170,050 – $215,950 | $170,050 – $215,950 |
35% | $215,950– $539,900 | $431,900 – $647,850 | $215,950– $539,900 | $215,950– $539,900 |
37% | $539,900+ | $647,850+ | $539,900+ | $539,900+ |
Long-Term Capital Gains
If an asset is held for more than one year before being sold, the resulting capital gain (or loss) is considered long-term. long-term capital gains are taxed at lower rates than normal income. For the 2022 tax year, long-term capital gains rates vary between 0% and 20% depending on income level. See the table below for details.
2022 Long-Term Capital Gains Rates
| Rate | Single | Married/Joint | Married/Separate | Head of Household |
|---|---|---|---|---|
0% | $0 – $41,675 | $0 – $83,350 | $0 – $41,675 | $0 – $55,800 |
15% | $41,675 – $459,750 | $83,350 – $517,200 | $41,675 – $258,600 | $55,800 – $488,500 |
20% | $459,750+ | $517,200+ | $258,600+ | $488,500+ |
How Can You Reduce or Avoid Capital Gains Tax?
There are a number of (legal) ways to fully or partially avoid paying capital gains taxes, and some—like 1031 exchanges and like-kind stock exchanges—involve fairly complicated paperwork and the aid of a financial professional. Others, however, are more straightforward. Below are a few simple ways to reduce capital gains taxes.
Hold Your Securities for More Than a Year Before Selling
The most straightforward way to reduce your capital gains taxes is to avoid short-term capital gains altogether. If you hold all securities for more than one year before selling them, they will be taxed at the long-term rate, which is lower than the short-term rate.
Invest Through a 401(k) or Individual Retirement Account
If you don’t need the funds you’ve made via capital gains right away, investing through an IRA or 401(k) can be a good way to reduce the impact of taxes on your gains. With a traditional IRA or 401(k) your contributions are tax-deferred, so you don’t pay income tax on them until they are withdrawn during retirement. Many folks fall into a lower tax bracket during retirement, so once they begin taking disbursements (which are taxed as ordinary income), they may be in a lower tax bracket.
Roth 401(k)s and IRAs can be even more advantageous. While contributions are taxed as ordinary income during the years they are made, withdrawals (and therefore any gains) are tax-free so long as they meet certain stipulations.
Give Securities to Family Members Before or After You Die
If you gift stocks or other securities to family members, they assume your cost basis, but if they sell, their capital gains (which were formerly yours) are taxed at their capital gains rate, so if they are in a lower tax bracket, they won’t have to pay as much as you would have.
Better yet, if you hold your securities until you perish, you can bequeath them to whoever you wish (like a family member). The current value of your securities at the time of your death becomes the recipient’s cost basis, so they could theoretically sell them immediately and pay $0 in capital gains tax.
Offset Capital Gains (or Reduce Income) With Capital Losses
Up to $3,000 in capital losses you incur by selling assets for less than you paid for them can be used to offset your capital gains in terms of taxes. Any leftover capital losses up to this $3,000 limit can be saved to use against future taxes once your current year's capital gains are offset.
This strategy is less than ideal, as it requires selling investments for a loss, but many investors do this toward the end of certain years if it ends up saving them more on their tax bill than they think they would make by continuing to hold certain securities.
Capital Gains Tax Example
Let’s say an individual purchased 10 shares of Alphabet Class A stock (GOOGL) on May 19th, 2021 for $2,308 per share ($23,080 total), then sold all of them on November 17th, 2021 for $2,981 per share ($29,810 total). What is their realized capital gain?
RCG = Sale Price – Purchase Price
RCG = $29,810 – $23,080
RCG = $6,730
So, the investor experienced a capital gain to the tune of $6,730. Because the 10 shares of GOOGL were held for less than a year before being sold, this would be considered a short-term capital gain for tax purposes.
Let’s say this investor made $97,000 in taxable income in 2021 and filed as single. Therefore, they would have fallen into the 24% tax bracket. So, how much would they have paid in capital gains tax on this sale?
24% of $6,730 is $1,615.20, which is the amount the investor would owe in capital gains tax for this stock sale. As you can see, capital gains taxes—especially those that are short-term—can eat into an investor’s profits significantly.
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors have about capital gains (and how they are taxed) that were not already covered in the sections above.
Are Capital Gains Considered Income?
Yes, once realized, capital gains are considered a sort of income. If held for over a year, however, they are taxed at a lower rate than normal income (See long-term capital gains tax rates table above).
Can Capital Gains Push You Into a Higher Tax Bracket?
No, capital gains, although they are a sort of income, are taxed separately from normal income. In other words, your capital gains are not added to your taxable income for the purpose of determining the tax rate you pay on your normal income. You may pay a higher or lower rate on your gains than on your normal income depending on your tax bracket and whether your gains are short or long-term.
Is There a Capital Gains Tax on Property Sales?
Yes, properties like homes are subject to capital gains taxes when sold. If owned for under a year, capital gains resulting from the sale of real estate are taxed at the same rate as your normal income. If owned for over a year, gains are taxed at the long-term rate.
That being said, the IRS allows for an exclusion of capital gains up to $250,000 for single filers and up to $500,000 for joint filers for capital gains resulting from the sale of a primary residence. In other words, if you are selling your own home—the one you live out of—you may be able to skip paying capital gains tax on the sale.
Are Capital Gains Taxable if They Are Reinvested?
Yes, once realized, your capital gains are taxable—even if you reinvest them in securities.