What Is the Capital Gains Tax?

The capital gains tax explained

Image shows a woman sitting at three computer monitors showing various charts and data. Text reads: “What is a capital gains tax? The capital gains tax is a government fee on the profit made from selling certain types of assets, including stock investments or real estate property. A capital gain is calculated as the total sale price minus the original cost of an asset. Tax only comes due once you sell your investment.”
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The Balance /  Mary McLain 

Definition

The capital gains tax is a government fee on your earnings from investments, like stocks or real estate property. Your earnings are known as your capital gain. You'll pay capital gains tax in the tax year you sell the asset, and the tax rate you pay depends on how long you've owned the asset and your income.

Key Takeaways

  • Capital gains taxes refer to the taxes you pay when you sell an investment for more than you paid to acquire it.
  • You will pay short-term capital gains if you owned the asset for one year or less, while more favorable long-term rates apply to investments held for more than a year.
  • Capital losses can offset your capital gains, and if your losses outnumber your gains, you can use capital losses to offset your wages from work.

How the Capital Gains Tax Works

The capital gains tax only becomes due once you sell your investment. For example, you won't owe tax while stock gains value inside your portfolio. However, once you sell your shares, the profit must be reported on your tax return. As a result, you pay a tax on your profit at the capital gains rate.

The federal government taxes all capital gains. Short-term capital gains or losses occur when you've owned an asset for a year or less. Long-term capital gains or losses occur if you sell an asset after owning it for longer than one year.

Short-term capital gains have a higher tax rate than long-term capital gains. This difference is deliberate to discourage short-term trading. Trading stocks and other assets frequently can increase market volatility and risk. It also costs more in transaction fees to individual investors.

Note

A capital loss occurs when you sell an asset for less than the original price. Some capital losses can be used to offset capital gains on your tax return, which lowers the taxes you pay.

Short-term Capital Gains Tax Rates

There are two standard capital gains tax rates. Capital gains are considered short-term if they are held for one year or less. All short-term capital gains are taxed at your regular income tax rate.

For example, if you buy 10 shares in XYZ Company on November 1 and sell them for a profit a month later on December 1, that profit would be considered a short-term capital gain.

Note

From a tax perspective, it usually makes sense to hold onto investments for more than a year.

Long-Term Capital Gains Tax Rates

Long-term capital gains refer to gains on investments held for more than one year. The tax rate paid on these capital gains depends on the income tax bracket. Those with taxable income of less than $80,801 (married filing jointly) or $40,401 (married filing separately, single) typically pay little or no capital gains tax.

For example, if you buy 10 shares of XYZ company on November 1 of this year, and then you sell them for a profit in December of the next year. In this case, 13 months have passed, and the profit you earn is considered a long-term capital gain.

Take a look at the chart below for a list of long-term capital gains tax rates.

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 Up to $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

Note

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

Example of the Capital Gains Tax

For example, let's say you buy a stock for $10 per share. You buy 10 shares for a total investment of $100. A little more than a year later, you sell those 10 shares for $12 each for a total of $120. In this situation, you have earned $20 in capital gains. These gains are "long-term" because you held them for more than a year.

That $20 in capital gains will be taxed at a rate corresponding to your total income for the year, including all of your earnings from your job. Let's say your total income for the year was $40,000, and you file taxes as an individual. In this case, your long-term capital gains tax rate is 0%, and you will not pay any taxes on that $20.

Capital Losses Can Offset Capital Gains

Taxpayers can declare capital losses on financial assets, such as mutual funds, stocks, or bonds. They can also declare losses on hard assets if they weren't for personal use. These include real estate, precious metals, or collectibles. Capital losses, either short- or long-term, can offset short- and long-term gains.

If you have long-term gains that exceed your long-term losses, you have a net capital gain. However, if you have a net long-term capital gain, but it's less than your net short-term capital loss, you can use the short-term loss to offset your long-term gain.

You can use net capital gain losses to offset other income, such as wages. But that's only up to an annual limit of $3,000, or $1,500 for those married filing separately. What happens if your total net capital loss exceeds the yearly limit on capital loss deductions? If you can't apply all of your losses in one tax year, you can carry the unused part forward to the next tax year.

How Capital Gains Taxes May Impact You

The top 1% of earners in the U.S. pay roughly 75% of capital gains taxes collected in an average year. If you include the 3.8% Net Investment Income Tax (NIIT) applicable to certain high income earners, those who live off of investment income may end up paying 23.8% in taxes, unless they take income from assets held for less than one year.

This taxation applies even to hedge fund managers and others on Wall Street, who derive 100% of their income from their investments. In other words, these individuals who earn their living from investments may ultimately pay a lower income tax rate than many average employees.

This taxing loophole has two outcomes:

  1. It encourages investment in the stock market, real estate, and other assets, which generates business growth.
  2. It creates more income inequality. People who live off of investment income already fall into the wealthy category. They've had enough disposable income in their life to set aside for investments that generate a healthy return. In other words, they didn't have to use all their income to pay for food, shelter, and healthcare.

The Tax Cuts and Jobs Act (TCJA) put more people into the 20% long-term capital gains tax bracket. They fall into that section when the IRS adjusts the income tax brackets each year to compensate for inflation. But these brackets will rise more slowly than in the past. The Act switched to the chained consumer price index. Over time, that will move more people into higher tax brackets.

Frequently Asked Questions (FAQs)

What are the capital gains tax rates?

Long-term capital gains tax rates are typically either 0%, 15%, or 20%. The rate you pay depends on your total annual income, but most people pay 15%. Short-term capital gains are taxed at your normal income tax rate. Gains on certain assets, such as collectibles, may be taxed at a rate of up to 28%.

What is the capital gains tax on real estate?

Capital gains taxes apply to real estate much in the same way they do to stocks. If you hold the real estate property for more than a year, then you'll qualify for the more favorable long-term capital gains rate (either 0%, 15%, or 20%). Unlike stocks, when you sell your home, you may qualify to exclude up to $250,000 ($500,000 for those married filing jointly) of your profits from taxation.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Internal Revenue Service. "Topic No. 409: Capital Gains and Losses."

  2. Internal Revenue Service. "26 CFR 601.602: Tax Forms and Instructions," Page 8.

  3. Internal Revenue Service. "Publication 550, Investment Income and Expenses (Including Capital Gains and Losses)," Pages 49 and 66-67.

  4. Congressional Research Service. "Capital Gains Taxes: An Overview of the Issues," Page 14.

  5. Internal Revenue Service. "Topic No. 559 Net Investment Income Tax."

  6. Congressional Budget Office. "Increase Individual Income Tax Rates."

  7. Internal Revenue Service. "Topic No. 701 Sale of Your Home."

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