Taxes on Capital Gains

Filed Under: Income Tax Basics, Tax Advice
When you invest in stocks, bonds and other capital assets, you may also owe capital gains taxes on the profits from the sale of those investments.

Generally, if you sell an asset at a higher price than what you paid, you earn a capital gain. If you sell at a lower price than what you paid, you earn a capital loss.

The amount of capital gain is calculated by subtracting the basis from the price for which you sell the asset. You generally add the transaction costs to buy the asset to your basis.

The length of time that you hold your investment determines whether your capital gain is treated as a long- or short-term gain. The IRS sets the cutoff period at one year. That means that if you hold a capital asset for more than one year (i.e., 366 days), the capital gain you realize on its sale is considered a long-term capital gain. Short-term capital gains are those that you earn on sales of one year or less.

Short-term capital gains are taxed as ordinary income. Long-term capital gains, however, are taxed at a preferential rate. For all but the 10 and 15 percent tax brackets, the long-term capital gains tax rate is 15% on the sale of stocks, mutual funds and similar investments. Investors in the 10 and 15 percent tax brackets pay a long-term rate of 0% in 2008.

What kinds of income do stocks, bonds and mutual funds generate, and how is this income taxed?

Taxation on stocks. Stocks generate taxable income as dividends and capital gains. Generally, growth stocks don't pay dividends. Instead, investors expect to earn returns from an appreciation in the share price. Income stocks, on the other hand, generate regular dividend income. Since 2003, dividends have been taxed at the same rate as capital gains.

Taxation on bonds. Bonds are also called fixed-income securities since they often have a fixed coupon rate. As a result, the interest income that you earn is constant over the bond term. When you sell a bond for a higher price than you paid for it, you earn a capital gain. If you buy a bond at a discount and hold it to maturity, you earn a capital gain. If you buy a bond at a premium and hold it to maturity, you face a capital loss.

Taxation on mutual funds. With mutual funds, taxes are a little more complicated. That's because a mutual fund distributes capital gains and dividends from the portfolio of securities it holds. Distributed short-term capital gains are taxed as ordinary income and distributed dividends and long-term capital gains are taxed as long-term capital gains. When you sell shares of a mutual fund for a higher price than you paid, you pay either a short- or long-term capital gains tax, depending on how long you own the shares.

Investing has other tax rules related to capital gains, including:

The "wash-sale" rule. The "wash-sale" rule is aimed at preventing investors from selling a security to lock in a capital loss, immediately buying it back at a lower price. The IRS prohibits you from using the capital losses to offset capital gains if you buy back the same security within 30 days. To avoid being tripped up by the rule, you may wish to buy a different security that has a similar investment objective or similar risk characteristics to the one you sold.

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Offsetting capital gains with losses. The IRS allows you to offset your capital gains with capital losses. If your losses exceed your gains, you can offset up to $3,000 of ordinary income in a year. If you have a larger amount of capital losses, you can carry them forward to future years. This is called the capital loss carryover rule.

For example, if you buy 100 shares at $10 each, and the share price grows at 5% per year, the share price in a year is $10.50. Since you have 100 shares, the amount of your capital gain is $50 (transaction fees are ignored).

If you are in the 25% tax bracket and sell 365 days later, you owe $12.50 in income taxes. If you wait for an additional day, you owe $7.50 in capital gains taxes.

How does this affect your rate of return? In the first case, your net profit on the sale is $37.50 ($50 minus $12.50). Your rate of return is 3.75% ($37.50 divided by your original investment of $1,000). In the second case, your net profit is $42.50. This gives you a rate of return of 4.25%, an extra 50 basis points for waiting one additional day.

For more on capital gains, see IRS Pub. 544.

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18 comments

Rcom28 05:21:28 PM Jun 10 2008

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do you have to pay capitol gains on your first house sell?

Dodie1990 12:02:12 PM Mar 26 2008

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Use your lt cap gains this year Barack abd Hillary will raise cap gain rate guaranteed Hillary to 20% barack to 28% Vote McCain

DickMareGayer 06:23:41 PM Mar 11 2008

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Recently sold all stocks within an personal income trust....automaticaly transferred funds to an index annuity withing the same personal income trust (same tax id)

Believe any paper capital gains deferred....no distribution.....
Believe withdrawls if deferred until trustor dies will result in any gains being.. based on the value of the annuity at time of death..(zero base)

Any advice or comments appreciated...

PGMitchell 02:21:40 PM Mar 11 2008

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It used to be that Long Term Capital Gains were taxed only on 50% of the gain. Has this changed?

Jco070541 09:05:03 PM Mar 05 2008

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I saw this tax free capital gains and dividends reported on in Kiplinger magazine as affecting persons who are low/moderate income with a 15% bracket, but before I sell any stock with the expectation of having tax free profits, I must see it in an IRS publication print or on an IRS website.
Yes there is a limit of $3000 per year but you can take next year what you weren't able to take this year.

Harri85274 08:26:21 AM Feb 23 2008

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I got 'hit' with large capital gains on my fund, that more than doubled my income from last years tax. I personally did not sell shares, so technically I never recieved such amount. This maybe a stupid question but here goes. Are capital gains good for you? For the amount of capital gains the fund issued, forces me to shell out a large taxibility for the first time in my life. Also, I suspect that my fund made some money in order for getting those capital gains...how does one separate that amount from whatever gain one got in his funds?

LFAWIRE 02:05:43 PM Feb 21 2008

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How are coins or Gold Billion coins treated?

PJBYTHERIVER 10:27:19 AM Feb 18 2008

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Is there some way to income average your income for tax perpuses if you have a extra large capital gain in one year. Say one that more than doubles your income over what it has been in the last 3 years. john

Sampson2815 11:34:54 PM Feb 13 2008

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yes, you have to pay capital gains if you take the money. You need to put the 113,000 in escrow, and then you dont have to pay the tax. We learned this the hard way last year.

Kunzrm 02:22:02 PM Feb 08 2008

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If i sell my property that i have owned for 19 years and make a profit of 113000.00 dollars then buy a new property for 250,000.00 do i have to pay capital gains

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