What Is the Capital Gains Tax?

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 can also cost more in transaction fees to individual investors.

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.

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. Earn $44,625 or less in 2023, and you will typically pay little or no capital gains tax.

For example, say 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. You'll be taxed on it according to your taxable income.

Take a look at the chart below for the maximum 2023 income thresholds and capital gains tax rates.

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.

Do I Have To Pay Capital Gains Tax?

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)