Capital Gains: Definition, Rules, Taxes, and Asset Types

James Chen, CMT is an expert trader, investment adviser, and global market strategist.

Amy is an ACA and the CEO and founder of OnPoint Learning, a financial training company delivering training to financial professionals. She has nearly two decades of experience in the financial industry and as a financial instructor for industry professionals and individuals.

Suzanne is a content marketer, writer, and fact-checker. She holds a Bachelor of Science in Finance degree from Bridgewater State University and helps develop content strategies for financial brands.

What Is a Capital Gain?

A capital gain refers to the increase in the value of a capital asset when it is sold. It occurs when you sell an asset for more than what you originally paid for it.

Almost any type of asset you own is a capital asset. This can include a type of investment (like a stock, bond, or real estate) or something purchased for personal use (like furniture or a boat).

Capital gains are realized when you sell a capital asset by subtracting the original purchase price from the sale price. The Internal Revenue Service (IRS) taxes individuals on gains from the sale under certain circumstances.

Key Takeaways

• A capital gain is the increase in a capital asset's value and is realized when the asset is sold.
• They may apply to any type of asset, including investments and those purchased for personal use.
• The gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.
• Unrealized gains and losses reflect an increase or decrease in an investment's value but are not considered taxable.
• A capital loss is incurred when there is a decrease in the capital asset value compared to an asset's purchase price.

Understanding Capital Gains

As noted above, capital gains represent the increase in the value of an asset. These gains are typically realized at the time that the asset is sold, and are generally associated with investments, such as stocks and funds, due to their inherent price volatility. But they can also be realized on any security or possession that is sold for a price higher than the original purchase price, such as a home, furniture, or vehicle.

They fall into two categories:

• Short-term: Gains realized on assets that you've sold after holding them for one year or less
• Long-term: Gains realized on assets that you've sold after holding them for more than one year

Both short- and long-term gains must be claimed on your annual tax return. Understanding this distinction and factoring it into an investment strategy is particularly important for day traders and others who take advantage of the greater ease of trading in the market online.

Realized gains occur when an asset is sold, which triggers a taxable event. Unrealized gains, sometimes referred to as paper gains and losses, reflect an increase or decrease in an investment's value but are not considered a capital gain that should be treated as a taxable event. For example, if you own stock that goes up in price, but you haven't yet sold it, that is an unrealized gain.

The tax rates applied to capital gains are listed below.

A capital loss is the opposite of a capital gain. It is incurred when there is a decrease in the capital asset value compared to an asset's purchase price.

Capital Gains Tax

Short- and long-term capital gains are taxed differently. Tax-efficient investing can lessen the impact of these taxes. Remember, short-term gains occur on assets held for one year or less. As such, these gains are taxed as ordinary income based on the individual's tax filing status and adjusted gross income (AGI).

Long-term capital gains, on the other hand, are taxed at a lower rate than regular income. The exact rate depends on the filer's income and marital status, as shown below:

Special Capital Gains Tax Rules

Note that there are some caveats. Certain types of stock or collectibles may be taxed at a higher 28% rate, and real estate gains can go as high as 25%. Moreover, if capital gains put your income over the threshold for the 15% rate, the excess will be taxed at the higher 20% rate.

In addition, certain types of capital losses are not deductible. If you sell your house or car at a loss, you will be unable to treat it as a tax deduction. However, when you sell your primary home, the first $250,000 is exempt from capital gains tax. That figure doubles to $500,000 for married couples.

Individuals whose incomes are above these thresholds and are in a higher tax bracket are taxed 20% on long-term capital gains. High-net-worth investors may have to pay the additional net investment income tax, on top of the 20% they already pay.

Assets Eligible for Capital Gains

Not all investments are eligible for the lower rates. The following are some assets that are and are not eligible.

Capital Gains and Mutual Funds

Mutual funds that accumulate realized capital gains throughout the tax year must distribute these gains to shareholders. Many mutual funds distribute them right before the end of the calendar year.

Shareholders receive the fund's distribution and get a 1099-DIV form outlining the amount of the gain and the type: short- or long-term.

Undistributed long-term capital gains are reported to shareholders on Form 2439. When a mutual fund makes a capital gain or dividend distribution, the net asset value (NAV) drops by the amount of the distribution. This distribution does not impact the fund's total return.

Tax-conscious mutual fund investors should determine a mutual fund's unrealized accumulated capital gains, which are expressed as a percentage of its net assets, before investing in a fund with a significant unrealized capital gain component. This circumstance is referred to as a fund's capital gains exposure. When distributed by a fund, such gains are a taxable obligation for the fund's investors.

Example of Capital Gains

Here's a hypothetical example to show how capital gains work and how they're taxed. Let's say Jeff purchased 100 shares of Amazon (AMZN) stock on January 30, 2020, at $350 per share. He then decided to sell all the shares on Jan. 30, 2024, at $833 each. Assuming there were no fees associated with the sale, Jeff realized a capital gain of $48,300: [($833 x 100) - ($350 x 100)] = $48,300.

Jeff is single and earns $80,000 per year, which puts him in the income group ($47,025+ to $519,900 for individuals) that qualifies for a long-term capital gains tax rate of 15%.

Jeff should, therefore, pay $7,245 in tax ($48,300 x 0.15 = $7,245) for this transaction.

What Qualifies As a Capital Gain?

Broadly speaking, whenever you sell a capital asset for more than the price at which you originally bought it, this may result in a capital gain. However, there are many situations in which a capital gain may not be taxed. For instance, the first $250,000 from the sale of a home is exempt from the capital gains tax. (This number applies to single filers, and it doubles to $500,000 for those married filing jointly.)

At What Income and Age Do You Not Pay Capital Gains Tax?

For the tax year 2024, those whose income is $47,025 or less do not have to pay capital gains tax. There is no age-based criteria that exempts one from paying a capital gains tax. Previously, there was a tax law that provided homeowners over the age of 55 with a one-time capital gains exclusion, but it is not in effect.

How Are Capital Gains Taxed?

Capital gains are classified as either short-term or long-term, depending on the holding period. Short-term gains are defined as gains realized in securities held for one year or less, and are taxed as ordinary income based on the individual's tax filing status and adjusted gross income. Long-term gains are defined as gains realized in securities held for more than one year, and are usually taxed at a lower rate than regular income.

What Is a Net Capital Gain?

The IRS defines a net capital gain as the amount by which net long-term capital gain (long-term capital gains minus long-term capital losses and any unused capital losses carried over from prior years) exceeds net short-term capital loss (short-term capital gain minus short-term capital loss). A net capital gain may be subject to a lower tax rate than the ordinary income tax rate.

How Do I Avoid Capital Gains Tax on My House?

You can reduce capital gains tax on your home by living in it for more than two years and keeping the receipts for any home improvements you make. The cost of these improvements can be added to the cost basis of your house and reduce the overall gain that will be taxed.

The Bottom Line

Capital gains are the profits that are realized by selling an investment, such as stocks, bonds, or real estate. Capital gains taxes are lower than ordinary income taxes, providing tax advantages to investors over wage workers. Moreover, capital losses can sometimes be deducted from one's total tax bill.

For these reasons, a thorough understanding of capital gains taxes can make a big difference for an investor.