Personal Finance 101: Capital Gains Tax

101A reader wrote in wanting a simple explanation of a very hairy topic: capital gains and capital gains tax. I’m going to take a crack at explaining it in very simple terms, leaving out some of the specific vagaries of the United States tax code.

Whenever you buy something, then sell it for a higher value, you incur capital gains. For example, let’s say you buy a Wii at a store for $250, then sell it on eBay for $300. You’ve just incurred $50 of capital gains.

Under the United States tax code, you are required to pay taxes on capital gains. If you have held the item or asset for less than one year, it is considered a short term capital gain and you pay taxes on it equal to your normal tax rate. However, if you hold it for longer than a year, you are charged 15% tax on that amount (it’s 5% if you’re in the 10% or 15% income tax bracket).

So, let’s say that you’re making enough money so that you’re in the 28% tax bracket. If you bought the Wii and sold it a month later, you are charged short term capital gains tax on that Wii, you have to pay $14 in capital gains tax when you file your taxes. However, if you wait a year and a half after the purchase to sell the Wii, you pay only $7.50 in taxes, a savings of $6.50 on your tax bill.

It is this difference that is one of the big encouragements for long term investment. Let’s say you buy $5,000 worth of a particular stock and within six months it doubles in value. If you sell immediately (and are in the 28% tax bracket), you’re going to pay $1,400 in capital gains tax. But if you hold onto it for another six months (and it doesn’t go down), you can then sell it and incur long term capital gains tax, paying only $750. That’s $650 in savings in your tax bill.

Another note: before you figure up your final tax bill at the end of the year, you can subtract your capital losses from your capital gains. So, let’s say you bought $5,000 worth of stock and then sold it later for $4,000 – that $1,000 is considered a capital loss and is subtracted from the gain (short term losses are subtracted from short term gains and long term losses are subtracted from long term gains). This is why many people time the selling of their bad stocks to maximize their tax benefit – they may want to sell it in a particular calendar year, or hold onto it for a full year until it becomes a long-term capital loss.

What’s the story here? Uncle Sam tries to make it worthwhile for people to invest for the long term by giving people better tax rates if they do so. For investors, the “buy and hold” strategy has significant tax benefits over rapid trading of stocks.

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12 thoughts on “Personal Finance 101: Capital Gains Tax

  1. Vernon says:

    That is the best explanation of capital gains I have heard. Thanks for making it so simple. By the way, great article in the Des Moines Business Record this week.

  2. MoneyNing says:

    People in other countries should read more on the wikipedia site. Just search captial gains tax in google and you will find it since Trent’s explanation only applies in the states.

    Also, capital gains tax also applies to properties (houses) and there are many other taxes thare are associate with it that do not apply to just “stocks”.

    Btw, I do not believe re-selling a product is considered capital gains since you are not “gaining” from your capital, as you are merely doing business. The reason why I think it’s not considered capital gains is because all distributors would be filing under capital gains rules which just does not happen.

  3. Brip Blap says:

    The long-term capital gains tax treatment has got to be one of the very few instances where the tax code actually rewards correct behavior. Too bad there’s not an idea like a “super-long” term capital gains tax, where you don’t pay capital gains at all (or 2%, 5%, etc.) if you hold for 10+ years. That would really encourage people to invest and hold, even people like me who’ve given up on individual stocks in favor of index funds.

  4. Dennis says:

    Great article! Now in your Wii example, I had a question. How does this work for people who use ebay? Or for people that sell products at garage sales?

  5. Ted Valentine says:

    Dennis — If you’ve made a profit on selling an item, you’re supposed to report it as income or a capital gain, as appropriate.

    Most regular people not in business that sell things at garage sales or ebay sell things for less than they paid, so there is no income.

  6. Jamie says:

    Every once in awhile you hear about a CEO taking an annual salary of $1 (Steve Jobs, John Mackey). While this can seem rather noble, there is an ulterior motive. Your Capital Gains tax is determined by your income tax bracket. So, if you only make $1 in a given year, any long term capital gains you incur will be taxed in the lowest bracket (5%). It’s nice that they are helping the company by declining a salary, but it’s not entirely altruistic, in my opinion…

  7. MossySF says:

    The $1 salary deal only works if your total long term capital gains is less than the max for the 5% bracket. Once LTCG pushes your income above that limit, the rest of it is taxed at 15%. (Which is still better than regular income tax of course.)

  8. MossySF says:

    And the initial stock grant is full income. Only the gain ontop the grant is capital gains.

  9. Maura says:

    Dennis,

    People who sell on eBay regularly are in a “trade or business”. Their income is business income, not capital gains. Not only do they not get the long-term capital gains treatment, but they may have to pay self-employment tax too.

    But if you sell something on eBay that is not a regular business- like selling sports memorabilia that you have collected over the years, or selling an antique you inherited, then you would treat it as a long-term capital gain.

    By the way, inherited assets automatically get long-term capital gains treatment but assets acquired by gift may or may not get long-term treatment.

  10. Alinfavorofa Fairtax says:

    We can make this even simpler: fairtax.org

  11. DON DEETS says:

    ??? SHORT TERM LOSSES SUBTRACTED FROM GAINS. WHAT’S THE MOST DOLLAR AMOUNT FOR 1 YEAR THAT CAN BE USED? EXAMPLE PAID 30,000 FOR STOCK-SOLD FOR 20,000. 10,000 LOSS-CAN THIS BE DEDUCTED FROM TOTAL INCOME? DOES THE 3,000 RULE APPLY HERE?
    THANKS,DON

  12. Jessie says:

    Question regarding Capital Gain on Real Estate:

    In 1996 my wife and I purchased a house for $315,000. We lived in this house for 9 years. In March 2006, we purchased another house and moved there. We rented our first home since October of 2006 until September 2008. It is has been vacant since October 2008 and we are on the process of short selling the property. The offer that was submitted to the lender for approval was $670,000. My question is that, if the bank approves the offer at $670,000 are we going to be taxed for capital gain even we lived there for 9 yers in the past? If in case that someone think that we will be paying capital gain, could someone suggest what we should do. By the way, our current mortgage balance was $830,000. Please advice. Thanks.

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