Short-Term vs. Long-Term Capital Gains Tax

Daniel Penzing
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What Are Capital Gains?

Capital gains are defined as profits that you may earn by selling property that you have owned for a certain period of time. It is the money you earn from investing in something like stocks or real estate.

Now what are capital gains? Capital gains are earnings one may make through investments of some asset. To make a lot of money, just buy an asset, let it sit, and then sell it when the value has increased.

There are some direct tax consequences of holding any asset for a period that is too short and then selling it at a substantial gain. While you may not have to pay a sales tax on big investments such as real estate, stocks, and bonds, you need to keep in mind that some of those profits are taxed again, this time through the Capital Gains Tax.

While capital gains are usually taxed when their duration is long term, small profits that are earned through investments whose duration is short term don’t have to be taxed.

This is true if you hold an investment for less than a year and then sell it, you are likely to pay a small tax on the gains as well, but there is a different tax rule for those who have held it for over a year. Short term Capital Gains tax is 20% of the profit.

What Are Short-Term Capital Gain Taxes?

Capital gains taxes are paid on profits made through the sale of capital assets. What is a capital asset? You should know that a capital asset is something that is held for investment, rather than something which is used for personal or household purposes. It may include shares, bonds and also property, to name a few.

Short-term capital gains taxes are paid on profits made from the sale of assets which have been held for a period of twelve months or less. Long-term capital gains taxes are paid on profits made from the sale of assets which have been held for a period of longer than twelve months.

If someone doesn’t make any profits from the sale of an asset, then no capital gains tax will be payable. Even though capital gains will be turned into losses in that case, the loss will be deductible from other income, like your day job salary, so it could come down to some capital gains tax in the end.

If the capital asset does contribute to a profit, this will be added to an individual’s total income for that year, and the individual will be taxed on his or her total income. The capital gains tax is taxed at the same rate as your income tax.

Short-term capital gains tax is taxed at the same rate as your income tax, while long-term capital gains tax is taxed at a lower rate than regular income tax.

What Are Long-Term Capital Gain Taxes?

Long-term capital gains are profits made from the sale of assets held long term – more than one year. Long-term capital gains are taxed at a lower tax rate than short-term capital gains.

Roughly one-third of all capital gains are treated as long-term capital gains. Another third are considered short-term capital gains, while another third are considered to be zero-percent capital gains. (Note, the rate for short-term capital gains is actually the same as the normal tax rate; it just doesn’t get the long-term capital gains rate.)

Why does the Internal Revenue Service (IRS) provide a tax break for long-term capital gains? They’re hoping that long-term capital gains tax will provide an incentive to investors to hold on to their stocks for the long run. They even include stock dividends as long-term capital gains. With dividend paying stocks, investors can get a significant tax break if they hold on to their shares. That’s because when you reinvest your dividends, those dividends pay for the long-term capital gains tax.

What About Capital Losses?

You don’t get to take an unlimited number of tax-free capital losses each year, as there is a limit on the amount of capital losses you can deduct each year from your taxable income. This limit is referred to as the “capital loss deduction limit” and it’s based on the concept of “adjusted gross income,” or AGI.

Adjusted gross income, as we mentioned earlier, is the total amount of your gross income (which includes all taxable income and tax-exempt income) minus the total sum of all your deductions. The sum of your taxable income and your deductions is used by the IRS to determine your AGI. For the purposes of the capital loss deduction limit, your capital loss deduction is limited to the annual amount of “capital loss carryover” that you’re entitled to.

So the general rule is that your capital loss deduction limit equals the sum of the annual capital loss carryovers from prior years, with any additional deductions disallowed.

You can deduct capital losses from capital gains to get your taxable income down to zero. So depending on the amount of your capital gains, your capital loss deductions could put you in a zero tax bracket.

How to Save on Capital Gain Tax

When You're Selling Your Home?

The midterm elections are over and Congress is now working to finalize tax reform… a bill that will have a significant impact on individual income taxes, including reform of the capital gain tax.

As we get closer to tax reform, more and more discussion centers on the two main taxation options for individual capital gains: short-term gains and long-term gains.

Long-term capital gains refers to profits earned on non-inventory assets that you have owned for more than one year. Any asset that is held for less than one year is taxed at your regular income tax rate. The rules for short-term capital gains hold true for assets that are held for one year or less.

The amount of tax that you will be charged for these gains is based on your total taxable income and can differ dramatically.

Your Plan Is Unique to You

And You Alone.

Whether you’re putting together a business plan, a capital gains tax plan, or your will, you are not going to please everyone with it. There are going to be people who don’t agree with the direction you’re heading in at all, they don’t agree with the steps of the plan, and they don’t agree with the amount of time you’re willing to spend on the plan.

But ultimately, you’re the one who is directly impacted by your plan. It’s your business, your money, your capital gains taxes, and your financial future. You are the one who has to go to work every day to make the money that you’re going to eventually use to pay taxes on when you sell your investments.