What Are Capital Gains?

Capital Gains Explained

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A capital gain is the increase in an asset’s value from the time you acquire it to the time you sell it. Your capital gain is your profit. Capital gains are common on assets such as real estate, stocks, and mutual funds.

The IRS collects taxes on capital gains income, depending on how long you’ve owned the asset. Different tax rates are applied to short-term capital gains (on assets held one year or less) and to long-term capital gains.

Here’s how various capital gains are taxed so you know in advance how your earnings will affect your overall financial picture.

Definition and Examples of Capital Gains

A capital gain is the increase in an asset’s value between the time you buy it and the time you sell it. You've experienced a capital gain if you sell a capital asset for more than you paid for it. You've had a capital loss when you sell something for less than you paid for it.

The IRS uses an adjusted basis to determine if there’s been a capital gain. In most cases, the adjusted basis of an asset is simply the amount it costs you to buy it. The adjusted basis—and therefore the capital gain—is determined by the item’s fair market value when you receive it if you're given an item as a gift or you paid less than its full value.

How Capital Gains Works

You'll experience a capital gain any time you sell a capital asset for more than you initially bought it. Just about anything of value could result in a capital gain, but it most often applies to assets such as homes, investments properties, stocks, bonds, and other securities.

Imagine you bought 10 shares of stock in your favorite company, with each share valued at $100. One year later, the stock’s price has increased to $120, and you decide to sell. You bought the stock for a total of $1,000 ($100 x 10 shares), and you were able to sell it for $1,200 ($120 x 10 shares). You’ve therefore experienced a capital gain of $200, which will be subject to capital gains taxes.

It’s also possible to experience a capital loss when you sell an asset for less than you paid for it and that loss exceeds any capital gains you had for the year. The IRS allows you to deduct up to a certain amount to reduce your taxable income for the year when you have a capital loss.

Let’s say that you bought those same 10 shares of stock at $100 per share, but you were only able to sell them for $90 per share instead of for a profit. The shares were worth a combined $1,000 when you bought them and just $900 when you sold them. You experienced a capital loss of $100.

Capital gains and losses don’t just apply to the property you buy. Your gain could be subject to capital gains tax if someone gives you something of value and you sell it for more than it was worth when you received it.

Capital Gains and Mutual Funds

Capital gains work a bit differently when it comes to mutual funds. Unlike other assets, you don’t have capital gains only when you sell your shares.

Mutual fund managers buy and sell shares and pass earnings along to the fund shareholders in the form of distributions throughout the year. They’re still considered capital gains and will be subject to capital gains taxes even if you reinvest these distributions. Distributions will likely be considered short-term capital gains because these transactions occur throughout each year.

Types of Capital Gains

The IRS categorizes capital gains into two categories: short-term and long-term.

Short-Term Capital Gains Long-Term Capital Gains
Gains on assets held for one year or less Gains on assets held for more than one year
Taxed as regular income Taxed at 0%, 15%, or 20%, depending on taxable income

The distinction between short-term and long-term capital gains comes down to how long you own an asset before you sell it. Your capital gain is short-term if you hold an asset for one year or less and sell it for a profit. Any profit on assets you held for longer than one year before selling is considered a long-term capital gain.

This difference might not seem significant, but it affects the tax rate you’ll pay. Most people will pay a considerably lower tax rate on long-term capital gains.

How Much Is the Capital Gains Tax?

The tax rate you’ll pay on your capital gains depends on whether it's short-term or long-term and the amount of your taxable income. Short-term capital gains are taxed as regular income. The income tax brackets range from 10% to 37% through tax year 2022. 

The U.S. has marginal tax brackets. Each portion of your income is taxed based on the bracket it falls into. Your short-term capital gains could push some of your income into a higher tax bracket depending on how much you earn from other income sources.

Long-term capital gains are taxed differently than the rest of your income, and typically at a lower rate. There are three long-term capital gains tax rates for most individuals: 0%, 15%, and 20%.

Long-Term Capital Gains Tax Rates for Tax Year 2022

Capital Gains Tax Rate Taxable Income, Single Taxable Income, Married Filing Separately Taxable Income, Head of Household Taxable Income, Married Filing Jointly
0% Up to $41,675 Up to $41,675 Up to $55,800 Up to $83,350
15% $41,676 to $459,750 $41,676 to $258,600 $55,801 to $488,500 $83,351 to $517,200
20% $459,751 or more $258,601 or more $488,501 or more $517,201 or more

Income thresholds for tax rates can be adjusted annually for inflation. Those for 2022 are higher than they were in 2021.

Long-Term Capital Gains Tax Rates for Tax Year 2021

Capital Gains Tax Rate Taxable Income, Single Taxable Income, Married Filing Separately Taxable Income, Head of Household Taxable Income, Married Filing Jointly
0% Up to $40,400 $40,400 Up to $54,100 Up to $80,800
15% $40,401 to $445,850 $40,401 to $250,800 $54,101 to $473,750 $80,801 to $501,600
20% $445,851 or more $250,801 or more $473,751 or more $501,601 or more

Long-term capital gains on collectibles, such as stamps, coins, and precious metals, are taxed at 28%.

Key Takeaways

  • A capital gain is the profit you earn when you sell an asset for more than you paid for it.
  • The IRS classifies capital gains as either short-term or long-term. Short-term capital gains come when you own an asset for one year or less. Long-term capital gains apply when you hold an asset for more than one year.
  • Capital gains are subject to taxes, and the tax rate depends on your annual income and whether it was a short-term or long-term capital gain.
  • Capital gains work differently for mutual funds because you can experience and pay taxes on gains without selling your shares.

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