Martin has 16 years experience in Human Resources Information Systems, has a PhD in Information Technology Management, and a degree in Information Systems Management. He is an adjunct professor of computer science and computer programming.
If money is made (or lost) on an investment, the IRS would like to know. This lesson will define capital gains and losses and explain the tax framework for the different types of gains and losses.
Capital Gains and Losses
When you sell an investment or property, you incur a capital gain if you get more than you paid for it. If you held the asset more than one year, the gain is long-term; if held for less than a year the gain is a short-term gain.
On the other hand, a capital loss is the opposite: You sold the asset for less than what you paid.
We often think of capital gains (and losses) in terms of stocks and other investments. But the rules apply to real estate and other securities.
The tax laws for capital gains and losses can get complicated. Not all gains and losses are the same. If a gain or loss does NOT trigger taxation rules, it is considered unrealized. (We'll get to those later.) Realized gains or losses may be taxed. In other words, you made (or lost) the money, and now the IRS wants some of it.
But the actual taxation of the gain is a little more complicated. It all depends on your tax bracket. Let's take a look at each type of gain (or loss) and the tax implications.
Short-term gains follow the tax brackets of your standard income. If you are being taxed at 25%, that is the tax you will incur on short-term gains. Think of the day trader who constantly buys and sells stocks: Any gains made should be considered part of normal income, because this activity most resembles the daily work most of us do.
However, if you hang on to your investment for more than a year, you are spared the traditional tax treatment (for the most part).
Long-term gains (those held over one year) have a little more relaxed policy. The tax rates are 0, 15, and 20%. Even if you are in the 30 percent tax bracket, your maximum tax on a long-term gain is 20%.
The following table highlights the capital gains rates compared to the tax brackets.
Capital Gains Tax
15 - 15%
Helpful for retirees who have no taxable income
25, 28, 33, and 35%
Also applicable to some dividends
Also applicable to dividends
25% gains rate
Applicable to real estate that was depreciated
28% gains rate
Small-business stock and sales of collectibles
Let's say we invested in a mutual fund in 2014; we paid $5,000. In 2016, the value dropped to $2,500. We held it, keeping the unrealized loss (we'll get to that idea shortly), but then cut our losses in 2017 when the amount was $4,500. We almost made the money back but still had a loss of $500. We can only deduct the $500. This is because we sold the investment in 2017, not 2016.
There are differences between long-term and short-term losses, just as there are with gains. Yes, the time-frame is the same for each. The tax law requires that you net each type of loss against the matching gain.
Over 83,000 lessons in all major subjects
Get access risk-free for 30 days,
just create an account.
We had net short-term gains and losses of $7,000; subtract the net loss of $2,000. Final net gain is $5,000. The key issue here is that it is a SHORT-TERM gain and is taxed as normal income.
Unrealized vs Realized
We already mentioned gains and losses that are realized and unrealized.
An unrealized gain or loss has not been incurred yet. Companies will show these on their balance sheets: They may have made a profit on paper but not cashed out yet to realize the gain. There's no tax on these, but companies still must account for them.
Once you sell the asset, the gain or loss is then realized, and the tax structure we discussed earlier kicks in. A short-term gain (loss) is for assets held less than a year. Long-term gains (losses) apply to assets held longer than one year.
Recall the example of the loss on the sale of the mutual fund. Even though we had a loss in 2016 of $2,500, we can only deduct the loss we incurred in 2017 ($500) because that is when we sold the investment.
A capital gain occurs when an asset is sold for more than its purchase price. Conversely, if sold for less, the result is a capital loss. Capital losses also are taxed as short-term or long-term by taking the net of each type of gain/loss and producing a total. An unrealized gain or loss is a paper gain or loss (companies report these on balance sheets). As an investor, your gains or losses are reportable when they are realized (sold).
Did you know… We have over 220 college
courses that prepare you to earn
credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the
first two years of college and save thousands off your degree. Anyone can earn
credit-by-exam regardless of age or education level.