What is a ‘Capital Gains Tax’

A capital gains tax is a type of tax levied on capital gains, profits an investor realizes when he sells a capital asset for a price that is higher than the purchase price. Capital gains taxes are only triggered when an asset is realized, not while it is held by an investor. That means he can own stock shares, for example, that appreciate every year, but does not owe a capital gains tax on the shares until he sells them, no matter how long they’re held.

BREAKING DOWN ‘Capital Gains Tax’

Most countries’ tax laws provide for some form of capital gains taxes on investors’ gains, although laws vary from country to country. In Canada, for example, residents pay half of their marginal tax rate on capital gains. In the United States, individuals and corporations are subject to capital gains taxes each year on their annual net capital gains. Capital gains taxes apply to anyone who sells an asset for profit – unless that person sells and buys assets for a living, like a day trader. In that case, profits are taxed as business income, not capital gains.

Capital Gains Tax Rates

The Internal Revenue Service (IRS) taxes long-term capital gains (that is, on assets held more than a year) at different rates than other types of income. Under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) passed by Congress in May 2006, U.S. taxpayers in the two lowest tax brackets (which account for about two-thirds of all individual tax returns) pay no capital gains taxes. Those in the 25%-and-higher tax brackets pay a 15% rate on their capital gains; those in the top 39.6% bracket pay 20%. However, certain net capital gains are subject to a 25% to 28% tax rate, if they are from depreciated real estate or from collectibles.

The capital gains tax rate for short-term capital gains (on assets held under a year) is usually the same as the tax rate on earned income or other types of ordinary income. The same rules apply for long and short-term losses respectively.

Though they can both represent a profit, capital gains, which result from selling an asset, aren’t the same as dividends paid by an asset. In the U.S., dividends are taxed as ordinary income, for taxpayers in 15% and higher tax brackets.

Net Capital Gains

Net capital gains refers to the total amount of capital gains minus any capital losses. This means if an investor sells two stocks during the year, one for a profit and an equal one for a loss, the amount of the capital loss on the losing investment counteracts the capital gain from the profitable investment. As a result, the taxpayer has zero net capital gains, meaning he does not incur any capital gains tax.

Investors who have both long and short term gains and losses can easily compute their final net gain. First, it is necessary to add all like-kind gains and losses together. For example, if an investor has four short-term gains, then these amounts must be added together to get a final total of all short-term gains. The same thing must be done with long-term gains and long and short-term losses. Then, when each type of gain and loss has been aggregated into four separate totals, the short-term gains are netted against the short-term losses to produce a net short-term gain…