In this week’s post, I explain the taxation of capital gains.
A capital gain comes from selling a capital asset for more than its cost basis. For example, if you sell a share of stock for $100, and your cost basis is $70, your capital gain would be $30 (100 – 70 = 30). Depending on the circumstances, capital gains can receive special tax treatment.
As with numerous tax topics, there are many exceptions and particular rules for different circumstances. In order to keep this post simple, we will be focusing on the taxation of investment securities, such as: stocks, bonds, mutual funds, and exchange traded funds (ETFs).
What is a capital asset?
A capital asset is basically any asset that is owned for investment or personal use. Examples of capital assets, include: stocks, bonds, mutual funds, exchange traded funds (ETFs), investment property, personal residence, collectibles, cars, etc. In this post, we will focus on investment securities, such as: stocks, bonds, mutual funds, and exchange traded funds (ETFs). There are special rules for other types of assets, that we will plan to cover in future posts.
How is capital gain calculated?
As mentioned in the introduction, in order to calculate the gain on the sale of a capital asset, start with the proceeds from the sale and subtract the cost basis. If you would like learn more about cost basis, see this post from a couple of weeks ago. In most circumstances, cost basis is the investment in an asset. For example, if an investor purchases a share of stock for $60, this purchase price is their cost basis (there can be certain adjustments to cost basis, which our previous post covers). If the investor sells this share of stock for $80, their gain would be $20 (80 – 60 = 20):
Holding period
The tax treatment of capital gains is dependent on the holding period of the capital asset (how long the asset has been owned). Gains/losses are short-term if the asset is held for one year or less. Gains/losses are long-term if the asset is held for more than one year. Here are a couple of examples:
You’ll notice that Stock B was held for 11.5 months, resulting in it being classified as a short-term capital gain. If it was held for just a couple more weeks, to bring the holding period to more than a year, the sale would become a long-term capital gain.
As with other areas of taxation, there are some exceptions to the holding period requirements.
Special tax rates for long-term capital gains
Short-term capital gains are taxed at ordinary income rates – the same rates of “normal” income, such as wages. Long-term capital gains are taxed at special rates depending on filing status and taxable income (these rates are for tax year 2023):
Long-term capital gains income “stacks” on top of regular income after deductions – it can get a little complicated. However, just remember that long-term capital gains receive special tax treatment and are typically taxed federally at 15% for most moderate income earners.
Gains/losses net against each other to arrive at a net capital gain. We will plan to discuss the "netting" process in a separate post. There are also special rules for how losses are treated. There is also the net investment income tax, which is an additional, special tax on investment income for higher income earners. Again, we will plan to cover these topics in future posts.
There can be separate state taxes on capital gains as well. For example, Virginia taxes capital gains the same as other income, with a top rate of 5.75%. A Virginia taxpayer paying 15% in federal capital gains would pay an additional 5.75% in state tax, for a total of 20.75%.
Examples
The examples below are meant to emphasize and show the unique taxation of long-term capital gains. As usual, some complexity has been left out to make the examples easier to understand.
John and Rachel have married filing jointly status. They have combined wages from both of their jobs of $120,000. They use the standard deduction of $27,700. They also have realized long-term capital gains of $30,000 from selling appreciated stock. Their regular (non-capital gain) income after deductions is $92,300 (120,000 – 27,700 = 92,300), which is greater than $89,250 (the start of the 15% capital gains taxable income range), so all their capital gains will be taxed at 15%. They will pay $4,500 of federal capital gains taxes (30,000 * 15% = 4,500):
Reese is a taxpayer with single filing status. He has $45,000 of wage income. Reese has $15,000 of itemized deductions (notice that he is itemizing, because his itemized deductions are greater than his standard deduction). He also has $20,000 of long-term capital gains from selling some mutual funds. Reese’s regular (non-capital gain) income after deductions is $30,000 (45,000 – 15,000 = 30,000). $30,000 is less than $44,625 (the top of the 0% capital gains taxable income range for single filing status), so some of the capital gains will be taxed at 0%.
$14,625 of the long-term capital gains will be taxed at 0% (44,625 – 30,000 = 14,625). The remainder, $5,375 (20,000 – 14,625 = 5,375) will be taxed at 15%. Reese’s total federal capital gains taxes will be $806 (5,375 * 15% = 806):
This example shows how the long-term capital gains income “stacks” on top of regular (non-capital gains income) after deductions.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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