Capital Gains Tax
What’s capital gains tax and when do I pay it?
Capital gains tax is charged on profits made from the sale of an investment. In other words, if you sell an investment for more than you paid for it, you may owe capital gains tax on your earnings. The exact rate you’ll pay is determined by your overall income level and how long you held the assets before selling. Unless you’re required to make estimated tax payments, you’ll pay capital gains tax when you file your income tax return.
Let’s look at an example:
Let’s say you buy 1 share of ABC Company for $10 in your taxable brokerage account. You later sell that share for $15. The result is a realized capital gain of $5. You’ll only owe capital gains tax on the $5 profit, not the entire $15. The original $10 is considered your “cost basis” - the amount invested.
What are realized and unrealized gains?
You “realize” capital gains when you sell an investment in your taxable brokerage account for more than you paid for it. If your investment has increased in value and you haven’t sold it, your gain is considered “unrealized.” You don’t owe capital gains tax on unrealized gains.
Does the length of time I own the investment affect my tax rate?
- Yes, the holding period matters.
- If you’ve owned your investment for more than 1 year before selling at a gain, you’re subject to long-term capital gains tax rates.
- If you’ve owned your investment for one year or less before selling at a gain, you’re taxed at short-term capital gains rates.
Short-term capital gains rates
Day traders and others taking advantage of the ease and speed of trading online need to be aware that any profits they make from buying and selling assets held less than a year are not just taxed—they are taxed at a higher rate than assets that are held long-term.
The short-term rate is determined by the taxpayer’s ordinary income bracket. For all but the highest-paid taxpayers, that is a higher tax rate than the capital gains rate.
Long-term capital gains rates
To encourage long-term investing, long-term capital gains receive special tax treatment. Most individuals are taxed either 0%, 15%, or 20% on their realized long-term capital gains. Investors subject to short-term capital gains rates are taxed at their ordinary income tax rate, which can range from 0% to 37%.
Most taxpayers pay a higher rate on their income than on any long-term capital gains they may have realized. That gives them a financial incentive to hold investments for at least a year, after which the tax on the profit will be lower.
What if I have more losses than gains?
If you sell your investment for less than you originally paid for it, you could be entitled to take a capital loss. When an investment is sold for less than its original purchase price, the difference in value is considered a capital loss. While we never want our investments to lose value, investors who realize a capital loss in their taxable brokerage accounts can potentially use that loss to lower their taxable income or offset future capital gains, through a strategy like tax-loss harvesting.
What’s tax-loss harvesting?
Tax-loss harvesting is when you intentionally sell securities at a loss to offset capital gains. You can offset all your capital gains with losses during the same tax year, plus up to $3,000 of ordinary income if you’re single or married, filing jointly (up to $1,500 each if you’re married, filing separately). You can use this strategy to lower your tax liability when rebalancing your portfolio.
Tax-loss harvesting only applies to taxable brokerage accounts. It can be complex, but it offers a sophisticated way to turn market volatility into a tax-savings opportunity.
Here’s an example of tax-loss harvesting:
Suppose you’re holding on to 1 share of ABC Company, which had a $5 gain, and 1 share of XYZ Company for $15, which had a $5 loss. If you sold both shares, your capital gain would be $0—the $5 loss would offset the $5 gain.
Now, imagine your 1 share of ABC Company had a gain of $10 and your 1 share of XYZ Company still had a loss of $5. If you sold both shares, your capital gain would be $5—the $5 loss would offset a portion of the $10 gain.