Capital gains refer to the profits earned when an asset is sold for more than its purchase price. The amount of time the asset was held determines whether the gains are considered long term or short term, which impacts how the gains are taxed. Understanding the differences between long term and short term capital gains is key for investors looking to maximize after-tax returns. This comprehensive guide covers everything you need to know about long term and short term capital gains.
What are Capital Gains?
Capital gains refer to the profits earned when you sell an asset for more than you paid for it. The most common assets that generate capital gains are stocks, bonds, precious metals, real estate, and collectibles.
For example, if you purchased a stock for $50 per share and later sold it for $75 per share, you would have a capital gain of $25 per share. Your total capital gain would be $25 multiplied by the number of shares sold.
Capital gains are categorized as long term or short term based on how long you held the asset before selling. The holding period determines how the gains are taxed.
Read More: Capital Gains Tax on Real Estate: A Detailed Guide
Key Points on Capital Gains:
- Capital gains refer to profits earned when selling assets for more than the purchase price
- Stocks, bonds, real estate, precious metals, and collectibles commonly generate capital gains
- Capital gains are classified as long term or short term based on the holding period
- Holding period determines how the capital gains are taxed
Long Term vs Short Term Capital Gains
The main factor that determines whether capital gains are long term or short term is the holding period of the asset.
Long Term Capital Gains
Long term capital gains come from selling assets held for more than one year. The long term capital gains tax rate is typically lower than the short term rate.
Short Term Capital Gains
Short term capital gains are earned on assets held for one year or less before being sold. Short term gains are taxed at the same rate as your ordinary income.
Here is a comparison of long term vs short term capital gains:
| Long Term Capital Gains | Short Term Capital Gains |
|---|---|
| Gains from selling assets held >1 year | Gains from selling assets held ≤1 year |
| Taxed at long term capital gains rates | Taxed at ordinary income tax rates |
| Typically 0%, 15% or 20% tax rate | Up to 37% tax rate |
| More tax-efficient than short term gains | Less tax-efficient than long term |
The holding period of assets is what determines whether gains qualify as long term or short term. Long term gains have preferential tax rates compared to short term.
Read More: Capital Gains Tax on Home Sales in the USA
What Assets Qualify for Long Term Capital Gains Treatment?
Many types of investment assets can generate long term capital gains if held for over one year. The most common qualifying assets include:
- Stocks: Buying and holding stocks for more than a year makes any gains long term. This includes common stock and preferred stock.
- Stock Mutual Funds: Capital gains distributions from stock mutual funds are generally classified as long term gains.
- Bonds: Gains from selling taxable bonds held for more than one year are subject to long term capital gains tax rates.
- Real Estate: Appreciation on real estate owned for more than 12 months qualifies for long term capital gains tax treatment. This can include residential or commercial property.
- Precious Metals: Gold, silver, platinum, and palladium coins or bullion generate long term gains when held over a year.
- Cryptocurrency: Cryptocurrencies like Bitcoin generate long term capital gains if held longer than a year before selling.
- Collectibles: Things like fine art and antique furniture can get long term capital gains treatment with a holding period exceeding 12 months.
The long term capital gains tax rates only apply when these and other capital assets are held for the required holding period before being sold.
Read More: Capital Gains Tax on Home Sales in Colorado
Key Points on Assets Qualifying for Long Term Gains:
- Stocks, bonds, real estate held 1+ year qualify for long term capital gains
- Mutual funds, precious metals, cryptocurrency also qualify if held for 1+ year
- Collectibles like art and antiques can get long term treatment after 12+ months
- The asset must be held for the required holding period to get long term tax rates
What Are the Long Term Capital Gains Tax Rates?
Long term capital gains tax rates are typically lower than short term rates. However, the long term capital gains tax you’ll pay depends on your total taxable income.
Here are the 2021 long term capital gains tax brackets based on income:
| Taxable Income | Long Term Capital Gains Tax Rate |
|---|---|
| $0 to $40,400 | 0% |
| $40,401 to $445,850 | 15% |
| $445,851 or more | 20% |
A few things to note about long term capital gains tax rates:
- The thresholds apply based on your total taxable income including all capital gains.
- Long term rates are tiered like income tax brackets, with different rates at different income levels.
- Most taxpayers will pay 15% long term capital gains tax or less based on their income.
- The top 20% rate applies only to high income taxpayers with income over $445,850.
Understanding the long term capital gains tax brackets allows you to estimate your tax liability on profitable investment asset sales.
Read More: Capital Gains Tax on Agricultural Land in Rural Areas
Key Points on Long Term Capital Gains Tax Rates:
- Maximum long term capital gains rate is 20%
- 0% rate applies to incomes under $40,400
- 15% rate applies to incomes from $40,401 to $445,850
- Top 20% rate is for taxpayers with income of $445,851+
- Bracket thresholds are based on total taxable income including capital gains
How Are Long Term Capital Gains Taxed?
When you sell assets for a profit after holding them long term, calculating capital gains taxes involves a few steps:
- Determine your cost basis – This is generally what you paid to acquire the asset plus any fees or commissions.
- Calculate your capital gain – Subtract your cost basis from the sale proceeds to find your capital gain.
- Classify the gain as long term – Confirm the holding period was over 12 months to classify the gain as long term.
- Apply the appropriate tax rate – Use the long term capital gains tax brackets to determine your tax rate.
- Report the gain – Report the long term capital gain on Schedule D and Form 1040.
- Pay capital gains taxes owed – Any capital gains taxes owed must be paid by the filing deadline, generally April 15.
The long term capital gains tax rates provide more favorable tax treatment compared to ordinary income rates. Proper reporting and payment of taxes is required on long term capital gains.
Key Points on How Long Term Capital Gains Are Taxed:
- Determine cost basis and calculate capital gain amount
- Confirm holding period over 12 months for long term treatment
- Use income level to identify long term capital gains bracket and tax rate
- Report gain on Schedule D and Form 1040 and pay taxes owed by filing deadline
What Is the Long Term Capital Gains Tax Rate on Real Estate?
Gains from selling real estate held long term are taxed like other long term capital gains. But real estate sales often qualify for additional exemptions.
The capital gains on real estate held for over a year are subject to the standard long term capital gains brackets:
- 0% for taxpayers under $40,400 in income
- 15% for incomes from $40,401 to $445,850
- 20% over $445,850 in income
However, real estate investors can also benefit from the capital gains exclusion on sale of a primary residence. When selling a primary home:
- Individuals can exclude up to $250,000 in gains
- Married couples can exclude up to $500,000 in gains
This applies if you lived in the home 2 of the past 5 years. The capital gains exclusion lowers taxes on home sales.
Key Points on Long Term Capital Gains Tax for Real Estate:
- Follows the standard long term capital gains brackets based on income
- Primary residence sales qualify for capital gains exclusion up to $250K/$500K
- Exclusion lowers taxable gain for individuals selling primary home after living there 2 of past 5 years
What Is Considered Long Term Investment Income?
Long term investment income refers to profits and distributions generated from assets held for over one year. Some examples include:
Long Term Capital Gains: As discussed previously, capital gains from selling assets you owned longer than 12 months benefit from preferential tax rates compared to short term gains.
Stock Dividends: Dividends paid out on stocks held long term are considered qualified dividends and taxed at long term capital gains rates.
Bond Interest: Interest income from some long term bonds, like municipal and US Treasury bonds, is exempt from federal taxes.
Mutual Fund Distributions: Capital gains distributions from stock mutual funds are generally classified as long term gains regardless of holding period.
Rental Income: Appreciation on rental real estate held long term benefits from lower capital gains tax when sold. Rental profits are also considered long term passive income after 1+ years.
In summary, long term investment income includes capital gains, dividends, interest, and rentals from assets held over one year.
Key Points on Long Term Investment Income:
- Long term capital gains from selling assets owned 1+ year
- Stock dividends if underlying shares held long term
- Municipal and Treasury bond interest
- Mutual fund capital gain distributions
- Rental real estate income after 1+ year ownership
How to Minimize Taxes on Long Term Capital Gains
There are several strategies investors can use to reduce taxes on long term capital gains:
- Harvest losses to offset gains: Selling assets at a loss can offset capital gains, lowering your tax liability. This strategy, known as tax loss harvesting, reduces net capital gains.
- Hold assets over one year: Holding assets long enough to qualify for long term treatment allows you to benefit from preferential tax rates compared to short term rates.
- Use retirement accounts: Gains in 401Ks, IRAs, and other retirement accounts can compound tax-free, avoiding capital gains taxes until retirement.
- Donate appreciated assets: Donating appreciated assets to charity eliminates capital gains taxes and allows you to deduct the asset’s full market value.
- Leave assets to heirs: Leaving assets to heirs through your estate allows them to inherit the assets with a stepped-up cost basis and avoid realization of capital gains.
- Manage income limits: Monitoring your total taxable income can prevent you from crossing into a higher capital gains bracket in any year.
Careful planning and gain realization strategies can help investors maximize returns over the long run by optimizing capital gains taxes.
Key Points for Minimizing Long Term Capital Gains Taxes:
- Harvest investment losses to offset capital gains
- Hold assets over 12 months to get long term tax rates
- Use retirement accounts for tax-deferred growth
- Donate appreciated assets to avoid tax and get deduction
- Leave assets to heirs with stepped-up basis to avoid gains
- Manage income levels to prevent moving into a higher tax bracket
Frequently Asked Questions
What is the difference between long term and short term capital gains?
The main difference is the holding period of the asset. Long term capital gains come from selling assets held for over 12 months. Short term gains apply to assets held for 12 months or less before being sold. The holding period determines the tax rate applied to the gains.
What tax rate do short term capital gains have?
Short term capital gains are taxed at your ordinary income tax rate, which ranges from 10% to 37% depending on total taxable income. Long term capital gains have preferential rates from 0% to 20%.
What types of assets can generate long term capital gains?
Many types of investments can produce long term capital gains if held for over one year, including stocks, bonds, mutual funds, real estate, precious metals, collectibles, and cryptocurrency. The asset must be held long term to qualify for lower tax rates.
Are long term capital gains taxed annually?
Long term capital gains are only taxed when you sell the asset and realize the gain. However, mutual funds may generate capital gain distributions annually that are considered long term gains regardless of your holding period.
Can I deduct long term capital losses against ordinary income?
No, capital losses can only be used to offset capital gains. However, you can carry forward unused capital losses to future tax years to offset gains in those years, up to the annual limit.
What are some strategies to minimize taxes on long term capital gains?
Strategies to reduce long term capital gains taxes include tax loss harvesting, holding assets long term, donating appreciated assets to charity, using retirement accounts, leaving gains to heirs, and managing your income to avoid crossing into a higher bracket.
Conclusion
Understanding long term and short term capital gains is crucial for investors aiming to optimize returns. Key takeaways include:
- Long term capital gains have preferential tax rates compared to short term gains
- Holding period of over 12 months qualifies gains as long term
- 0%, 15%, and 20% long term capital gains tax brackets apply based on income
- Various assets like stocks, bonds, real estate generate long term gains if held long enough
- Tax minimization strategies can help lower long term capital gains tax liability
Planning ahead and employing tax-smart investing strategies can help you maximize portfolio growth and retain more of your investment earnings over time. Consult a financial advisor or tax professional for guidance tailored to your situation.
This guide provided a comprehensive overview of the differences between long and short term capital gains, from definition and tax rates to examples and planning strategies. Understanding these concepts can position investors to better navigate taxes on their investment income and returns.
