A refresher on how short-term capital gains work and how they are taxed is useful for investors seeking to minimize the tax implications of investment decisions. If you are contemplating the sale or purchase of property or another investment asset, you may decide to alter the timing based on whether a shift can move a gain from the short-term category to long-term.
In general, a capital gain is an increase in a capital asset's worth over its basis. An asset can be property or an investment, and the basis (sometimes referred to as tax basis) is the original cost plus any out-of-pocket expenses like closing costs. For example, if the taxpayer buys property for $2,000,000 plus $100,000 in acquisition expenses, the property's basis is $2.1 million. Other adjustments, such as depreciation, can be calculated over time, but these are unlikely to be relevant for a short-term capital gain.
Capital gains are short-term if the taxpayer holds the asset for less than one year, and the profit will be subject to the investor's ordinary-income tax rate. The calendar starts running on the day after you acquired the asset and goes up to and including the day you dispose of it. A "buy and hold" strategy in equity investments has a more favorable tax treatment than one which involves more frequent transactions—like day trading. However, short-term losses are initially deductible against short-term gains before being deducted from long term gains. This rule means that if you have a larger short-term loss, you can subtract it from the gain that is likely subject to the higher tax rate of ordinary income. You may want to consider timing realization of losses to balance short-term gains if possible. Also, a loss that is not fully offset by increases in one tax year can be carried over to another year, subject to some limitations and specific provisions.
Will a short-term capital gain push my ordinary income into a higher tax bracket?
No, because U.S. income taxes are progressive. As a taxpayer, you pay taxes on your ordinary income at the rate for the bracket the income belongs to. Suppose you have $100,000 in income from wages and $20,000 in gains from short-term investments. Tax rates on your ordinary income will range from the lowest 10% rate for the first $9,875 up to 24% for the amount between $85,525 and $100,000. The $20,000 of the short-term gain will fall into that 24% category as well. The higher income is taxed at the higher amount, but having the income reach the higher bracket doesn't change the tax rate on the lower amounts.
Now consider a scenario in which you deferred the asset's sale that netted the $20,000 gain until it became a long-term gain instead of short-term. Rather than being subject to a 24% tax rate as ordinary income, The IRS would tax the $20,000 at 15%. The tax bite drops from $4,800 to $3,000. This example is just an illustration, of course, and we always recommend that you consult a tax advisor for specifics. The takeaway is that the tax code is meant to encourage holding assets rather than frequent transactions.
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