Capital Gains: Definition, Rules, Taxes, and Asset Types

What Is a Capital Gain?

A capital gain refers to the increase in the value of a capital asset that is realized when it's sold. A capital gain occurs when you sell an asset for more than what you paid to purchase it. The Internal Revenue Service (IRS) taxes individuals on capital gains under certain circumstances.

Almost any type of asset you own is a capital asset. They can include investments such as stock, bonds, or real estate, and items purchased for personal use, such as furniture or a boat.

Understanding Capital Gains

Capital gains represent the increase in the value of an asset. These gains are typically realized at the time the asset is sold, and they're often associated with investments, such as stocks and funds, due to their inherent price volatility.

But they can also be realized on any security or possession that's sold for a price higher than the original purchase price, such as a home, furniture, or vehicle.

Short- and Long-Term Capital Gains

Capital gains fall into two categories:

• Short-term: Gains realized on assets that you've sold after holding them for one year or less
• Long-term: Gains realized on assets that you've sold after holding them for more than one year

Both short- and long-term gains must be reported on your annual tax return. Understanding the distinction between them and factoring it into an investment strategy is particularly important for day traders and others who trade securities online.

Realized gains trigger a taxable event. Unrealized gains, sometimes referred to as paper gains, reflect an increase in the value of an investment that hasn't been sold. For example, if you own stock that goes up in price, but you haven't yet sold it, you have an unrealized gain. It's not a taxable event.

Capital Gains Tax

Short- and long-term capital gains are taxed differently. Tax-efficient investing can lessen the impact of these taxes.

Short-term gains are taxed as ordinary income at a rate based on an individual's tax filing status and adjusted gross income (AGI).

Long-Term Capital Gains Tax Rates: 0%, 15%, 20%

Long-term capital gains are taxed at lower rates than ordinary income tax rates. These rates are 0%, 15%, and 20%, although some assets such as collectibles can be subject to a maximum rate of 28%.

The exact rate that will be applied to your long-term capital gain depends on your taxable income and filing status. The 0% and 15% rates apply as long as income stays at or under a certain maximum amount that's adjusted annually to keep pace with inflation. If you have more income than the maximum amount allowed for the 0% rate, the gain is taxed at the 15% rate.

If you have more income than the maximum amount allowed for the 15% rate, the gain is taxed at 20%.

Special Capital Gains Tax Rules

Note that there are some caveats. Certain types of stock or collectibles may be taxed at a higher 28% rate, and real estate gains can go as high as 25%.

In addition, certain types of capital losses are not deductible. If you sell your house or car at a loss, you will be unable to treat it as a tax deduction. However, when you sell your primary home, the first $250,000 is exempt from the capital gains tax. That figure doubles to $500,000 for married couples.

High-net-worth investors may have to pay an additional net investment income tax on top of the 20% they will most likely owe.

Assets Eligible and Ineligible for Lower Tax Rates

Not all investments are eligible for the lower long-term capital gains tax rates.

Capital Gains and Mutual Funds

Mutual funds that accumulate realized capital gains throughout the tax year must distribute these gains to shareholders. Many mutual funds distribute them right before the end of the calendar year.

Shareholders who receive a distribution will get a 1099-DIV form detailing the amount of the capital gain and the type: short- or long-term.

Undistributed long-term capital gains are reported to shareholders on Form 2439. When a mutual fund makes a capital gain or dividend distribution, the net asset value (NAV) drops by the amount of the distribution. This distribution does not impact the fund's total return.

Taxes

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, such gains are a taxable obligation for the fund's investors.

Example of Capital Gains

Here's a hypothetical example to show how capital gains work and how they're taxed. Let's say an individual purchased 100 shares of Amazon (AMZN) stock on Jan. 30, 2022 at $350 per share. They then decided to sell all the shares on Jan. 30, 2026 at $833 each. Assuming there were no fees associated with the sale, they realized a capital gain of $48,300: ($833 x 100) - ($350 x 100).

This individual is single and has taxable income of $80,000 per year, which puts him in an income group that qualifies for a long-term capital gains tax rate of 15%. They would therefore owe $7,245 in tax ($48,300 x 0.15) for this long-term capital gain.

The Bottom Line

Capital gains are the profits that are realized by selling an asset for a profit, such as stocks, bonds, or real estate. Long-term capital gains taxes are lower than ordinary income taxes, providing a tax advantage to many taxpayers, including homeowners and investors. Moreover, capital losses can sometimes be deducted from one's total tax bill.

For these reasons, all those holding assets that they may sell should understand when and how capital gains taxes apply.