Taxable Events: What Is a Capital Gain?

To encourage certain types of investing, the government distinguishes investments by prioritizing tax treatments. The government offers favorable tax treatments for some types of investment over other types of investments.

One distinction in the tax code is the tax treatment of capital gains. This is based on type of investment, the duration of the investment, and income level. Lower tax rates are offered on investments held for longer period of time, as an incentive to encourage long-term investments over short-term profits.

As an investor, it is important to understand how your investments are taxed and take these rules into consideration while you’re making investment decisions.

The capital gains tax is the levy on the profit that an investor makes when an investment is sold. You will owe capital gains tax for the year that you sell the investment. Capital gains represent the increase in the value of an asset. Every capital asset has a cost basis, which is typically what you paid for the asset plus any money invested towards improving it. These gains are typically realized at the time that you sell the asset.

Capital gains are generally associated with investments such as stocks, funds, and cryptocurrency due to their inherent price volatility. But capital gains can also be realized on any security or possession—such as a home, furniture, collectibles, or a vehicle—that is sold for a price higher than the original purchase price.

Proponents of a low rate on capital gains argue that it is a great incentive to save money and invest it in stocks and bonds. That increased investment fuels growth in the economy. Businesses have the money to expand and innovate, creating more jobs.

The Long and Short of It

Capital gains fall into two categories:

• Short-term capital gains are those realized on assets that you’ve sold after holding them for one year or less.
• Long-term capital gains are realized on assets that you’ve sold after holding them for more than one year.

You must claim both short-term and long-term gains on your annual tax return. Understanding this distinction and factoring it into investment strategy is particularly important for day-traders and others who take advantage of the greater ease of trading in the market online.

When a capital asset is sold, the difference between the sales price and cost basis is either a capital gain (if the sales price is higher than the cost basis) or a capital loss (if the sales price is lower than the cost basis). Realized capital gains occur when an asset is sold, which triggers a taxable event. Unrealized gains, sometimes referred to as “paper” gains and losses, reflect an increase or decrease in an investment’s value but are not considered a capital gain that should be treated as a taxable event.

Short-term and long-term capital gains are taxed differently. Short-term gains are taxed as ordinary income based on the individual’s tax-filing status and adjusted gross income. Long-term gains are taxed at a lower rate than regular income.

For 2022 capital gains, most individuals are taxed 15% on long-term capital gains if their income falls below $459,750 for a single filer, $258,600 for married couples filing separately, $488,500 for the head of a household, or $517,200 for married couples filing jointly.

For 2023 capital gains, most individuals are taxed 15% on long-term capital gains if their income falls below $496,300 for a single filer, $276,900 for married couples filing separately, $523,050 for the head of a household, or $553,850 for married couples filing jointly.

Individuals whose incomes are above these thresholds and are in a higher tax bracket are taxed 20% on long-term capital gains. Those who earn $41,675 or less ($83,350 or less for those married filing jointly) pay 0% on long-term capital gains.

Capital Gains and Mutual Funds

Mutual funds that accumulate realized capital gains throughout the tax year must distribute those tax liabilities to their shareholders. Many mutual funds distribute capital gains right before the end of the calendar year. It is therefore possible for shareholders to be allocated a capital gains tax bill from mutual fund trades within the fund earlier in the year but  be at an unrealized total return loss in their position with the fund.

Shareholders receive the fund’s capital gains distribution and get a form (1099-DIV) outlining the amount of the gain and the type—short-term or 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.

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.

Net Capital Gains and Home Sale Exclusion

The IRS defines a net capital gain as the amount by which net long-term capital gain (long-term capital gains minus long-term capital losses and any unused capital losses carried over from prior years) exceeds net short-term capital loss (short-term capital gain minus short-term capital loss). A net capital gain may be subject to a lower tax rate than the ordinary income tax rate.

Due to a special exclusion, capital gains on the sale of a principal residence are taxed differently than other types of real estate. Basically, if you sell your main home and have a capital gain, you can exclude up to $250,000 of that gain from your income, provided you owned and lived in the home for two years or more out of the last five years. For married couples filing jointly, the exclusion is $500,000.

Conclusion: Use Capital Losses to Offset Gains

Capital gains tax rates are the same for 2023 as they were in 2022: 0%, 15%, or 20%, depending on your income. The higher your income, the higher your rate. While the tax rates remain unchanged for 2023, the income required to qualify for each bracket goes up to adjust for inflation. The maximum zero-rate taxable income amount is $89,250 for married couples filing jointly and surviving spouses, $59,750 for heads of household, and $44,625 for married taxpayers filing separately.

 

If you experience an investment loss, you can take advantage of it by decreasing the tax on your gains on other investments. Because of recent market volatility, now may be a good time for some tax-loss harvesting. Say you own two stocks, one worth 10% more than you paid for it, while the other is worth 5% less. If you sold both stocks, the loss on the one would reduce the capital gains tax that you would owe on the other. Obviously, in an ideal situation, all your investments would appreciate, but losses do happen, and this is one way to get some benefit from them.

If your capital losses exceed your capital gains, either as a single filer or filing jointly you can use up to $3,000 of the loss to offset ordinary income for the year. After that, you can carry over the loss to future tax years until it is exhausted.

Investors who are trying to offset capital gains with their losses used to be able to sell their investments at a loss and then immediately rebuy them, which is known as a wash sale. They could capture that loss without any actual damage to their portfolio, until the IRS implemented the wash-sale rule, which requires that you wait 30 days before rebuying to realize those losses.

Tax planning should never be the sole factor driving an investment strategy, but it can be a factor. When possible, holding onto your investments for more than a year before you even think of selling them can be a big advantage when it comes to paying taxes on your capital gains.

Whether you sell your assets after a few months or a few years, be sure to keep good records of what you bought and sold, when the transaction took place, and how much you paid or received for it.

Also, there are exceptions to every rule. So, if you are not sure about the cost basis, whether it is a short-term or long-term gain or loss, consult your financial adviser or an accountant.