Capital Gains Tax Explained
October 8, 2020
By Rahul Iyer
When certain assets such as real estate or stocks are sold, they become subject to capital gains tax. In this article, we will discuss what capital gains tax is and how it works.
Capital gains tax refers to money due to the government from the sale of certain assets. Real estate and stocks are examples of assets that may become subject to capital gains tax when they are sold. A capital gain is arrived at by subtracting the original cost of the asset from the price at which it was sold. If this figure is positive, you would have experienced capital gains.
In the case of an asset being sold for less than what it was purchased for, a capital loss would be reported. Capital losses have a lowering effect on your overall taxes. It can be used to balance the effect of capital gains on your tax bill.
Bear in mind that you only pay capital gains tax when the investment is sold. This means that while the investment is still owned by you, you will not need to pay taxes as its value increases or appreciates. At the point of the asset’s sale, you will be required to pay taxes on capital gains.
The Difference Between Short-Term and Long-Term Capital Gains
All capital gains are subject to government taxes. When an asset produces capital gains and is sold within a one-year period, this is considered by the government as short-term capital gains. When an asset produces capital gains and it is held for longer than a year before it is sold by the owner of the asset, the government classifies this as a long-term capital gain.
When you sell an asset that has increased in value within a year, the tax that you will be required to pay the government is calculated at a higher rate than long-term capital gains. This is done by the government to deliberately reduce interest in short-term trading. This is done to protect the marketplace. In the case of stocks, higher frequencies of trading can result in a riskier and more volatile stock market.
Short-term capital gains tax rate: the tax that you are required to pay on short-term capital gains is the same as income tax. To keep taxes down, it is a better option for you to hold assets for longer than a year.
Long-term capital gains tax rate: the income bracket in which you fall will determine the tax that you will pay on long-term capital gains. If you are in the 10% or the 12% income bracket, you will pay zero capital gains tax. If you fall in the top income tax bracket, you will be required to pay 20% on your long-term capital gains.
It is wise to consider the taxes before trading an asset. The wise investor will seek to keep assets for more than a year before selling them. This makes the tax expense on your investments much more favorable and will result in more earnings for you.