A capital gain is the profit earned on the sale of an asset such as a stock, bond, mutual fund, option, or piece of real estate. Just like income you earn from working, the profit you earn from the sale of a financial asset is subject to income tax. Income you earn from a job, however, is taxed at a different rate than a capital gain.
This ordinary income tax rate can be higher or lower than the capital gains tax rate. Just like your ordinary tax rate is dependent upon your income level, so is your capital gains tax rate. How much tax you pay on your capital gain also depends on the length of time you held the asset before selling it.
Short-term Capital Gains
A short-term capital gain is the profit you earn from selling an asset you’ve held for less than one year. Income earned on these assets gets taxed at your ordinary income tax rate. Short-term capital gains recognized in 2017 are taxed at a rate between 10 and 39.6 percent. The reason short-term gains are taxed at this high rate is because short-term investments are considered by economists to result more from the act of speculation than investment.
Long-term Capital Gains
A long-term capital gain is the profit you earn from selling an asset you’ve held longer than one year. Federal government tax policy rewards long-term, patient investors because long-term investment in an economy should contribute to stable and sustainable growth. As a result, the long-term capital gains tax rate is lower than the ordinary income tax rate. Long-term capital gains tax rates are between 15 and 20 percent.
The reason there are ranges of tax rates for both short-term and long-term capital gains is because capital gains tax is dependent upon overall taxable income. Tax rates in the United States are progressive taxes, which means people with a higher income pay a higher proportion of their income to the government. People with the least amount of income may pay as low as 10 percent tax on short-term capital gains while those in the highest tax bracket pay nearly 40 percent.
People in the lowest income brackets are actually exempt from paying taxes on long-term capital gains. In 2017, married couples filing jointly were exempt from paying long-term capital gains taxes as long as their combined taxable income was less than $75,900. Singles and married couples filing separately are exempt from paying long-term capital gains tax as long as their taxable income did not exceed $37,950.
Other Capital Gains
Although the rules for short-term and long-term capital gains on the sale of assets cover almost every situation, there are a few special situations with rules of their own. For example, if you earn a profit on the sale of fine art or collectible coins, those capital gains are taxed at a rate of 28 percent regardless of income level and length of time you held the investment.
If you sell stock of a small business, meaning one that is not publicly traded, the maximum capital gains tax rate is also 28 percent. Real estate assets have their own capital gains tax rules as well. Specifically, if you claimed a depreciation allowance on a real estate asset, the profit on the sale of that asset gets taxed at a rate of 25 percent regardless of income level or investment holding period.
Effective Rate of Return
It is important to consider income levels and tax rates not only for the amount of money someone could owe in taxes but also for how these factors influence the effective rate of return on the asset. As a simple example, consider the purchase of a single share of stock for $100 where you have a target required rate of return equal to 10 percent. The stock price goes up to $110, so you sell the stock and think you’ve earned 10 percent on the investment.
If you held the stock longer than one year, you still need to pay long-terms capital gains tax on the $10 profit. If you fall into a middle tax bracket, you’ll pay capital gains tax of $1.50 on your profit. That lowers your after-tax profit to $8.50 and the return on your investment to 8.5 percent.
The situation is worse if you sell the stock in less than one year because you’ll pay the higher ordinary tax rate on your short-term capital gains. If you fall into the middle tax bracket, you’ll pay 28 percent tax on your capital gain. In this example, that is $2.80 tax on the profit, and your after-tax effective rate of return is 7.2 percent. So before purchasing and selling an asset, it’s important to consider your planned holding period and your target after-tax required rate of return.