The capital gains tax is a levy on the gain, or increase, in the value of a capital asset over its basis. Capital assets include real estate, business property and equipment, jewelry, antiques, stocks, bonds, mutual funds, mineral rights, royalties, and some intellectual property like patents. The value is the amount that you sell it for or can sell it for, while the basis is the amount you paid, plus acquisition and improvement costs.
The gain is considered either short or long-term, and the tax treatment differs. Note that capital losses are also short or long-term. However, losses usually don't generate as much interest, although it's essential to keep them in mind to offset capital gains where possible. A short-term capital gain is an increase in the value of a stock or other capital asset the investor has owned for less than a year. In contrast, a long-term capital gain results from the disposition of assets held for a year or more.
Short-term gains are taxed like ordinary income—that means income from wages, salary, or self-employment. Those rates range from 10 percent to 37 percent and are progressive, so taxpayers pay the lower rate on income up to the threshold amount. Long-term gains are subject to lower capital gains tax rates, as low as zero percent and as high as 20 percent.
When do I pay taxes on the capital gain?
Taxes are incurred when you sell a stock or other equity or fund. For example, let's say that you buy 100 shares of XYZ stock at $10 per share, and nine months later, you decide to sell it because the value has increased to $25 per share. The gain you have made on that sale is $1,500 and is a short-term gain, meaning that you will pay taxes at your ordinary income rate. However, if you hold the stock for more than a year, you would have a long-term capital gain, and your tax rate would likely be lower.
What about a stock that I inherit?
Suppose your favorite uncle bought those 100 shares of XYZ stock for $10 each a long time ago and never sold them. Instead, he bequeaths them to you in his will. Once you learn of his generosity, you are shocked that the stock is now valued at $20,000 per share, nearly two million dollars. If you were to owe a capital gains tax, you would likely have to sell your valuable stock to pay the amount due. But you inherit the stock at its current value, regardless of the original basis. This scenario is called a step-up basis, which applies to many inherited capital assets. You can hold the stock (any value increases after you inherit it will result in capital gains) or sell it at the stepped-up value without owing capital gains taxes.
It's important to note that stock held in a retirement account doesn’t receive a step-up valuation. The same applies to money market funds, pensions, and tax-deferred annuities. These financial instruments have other tax advantages, however.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
