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 acquired it to the time you sold it. In other words, 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 depending on how long you’ve owned the asset. Different tax rates are applied to short-term capital gains—meaning gains on assets held less than one year—than are applied 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. If you sell a capital asset for more than you bought it for, you’ve experienced a capital gain. On the other hand, you experience a capital loss when you sell something for less than you bought it.

The IRS uses what’s called 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. In cases where you received an item as a gift or paid less than the full value, the adjusted basis—and therefore the capital gain—is determined by the item’s fair market value when you received it.

How Capital Gains Works

You 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 most often it applies to assets such as homes, investments properties, stocks, bonds, and other securities.

Imagine that 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. While you bought the stock for a total of $1,000 ($100 x 10 shares), you were able to sell it for $1,200 ($120 x 10 shares). You’ve experienced a capital gain of $200, which will be subject to capital gains taxes.

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

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

Capital gains and losses don’t just apply to the property you buy. If someone gifts you something of value and you sell it for more than it was worth when you received it, your gain could be subject to capital gains taxes.

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.

Throughout the year, mutual fund managers buy and sell shares and pass earnings along to the fund shareholders in the form of distributions. Even if you reinvest these distributions, they’re still considered capital gains and will be subject to capital gains taxes. Because these transactions occur throughout each year, distributions will likely be considered short-term capital gains.

Types of Capital Gains

The IRS categorizes capital gains into two different 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 big distinction between short-term and long-term capital gains comes down to how long you owned an asset before you sold it. If you hold an asset for one year or less and sell it for a profit, your capital gain is short-term. Any profit on assets you held for longer than one year before selling is considered a long-term capital gain.

While this difference might not seem significant, it really is when it comes to 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 how long you hold the asset before you sell it and how much your taxable income is.

Short-term capital gains are taxed as regular income. As of 2021, the income tax brackets range from 10% to 37%. 

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

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 2020

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 $40,000 Up to $40,000 Up to $53,600 Up to $80,000
15% $40,001 to $441,450 $40,001 to $248,300 $53,601 to $469,050 $80,001 to $496,600
20% $441,451 or more $248,301 or more $469,051 or more $496,601 or more

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%.

It is important to note that as of March 26, 2021, the IRS had not yet released an updated version of Publication 550, the information used for investment income and expenses, including capital gains and losses.

Key Takeaways

  • A capital gain is the profit you earn when you sell an item for more than you bought 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 since you could experience and pay taxes on gains without selling your shares.