Capital Gain

What Is Capital Gain?

Capital gain refers to the profit resulting from selling a capital asset or investment at a price higher than its purchase price. The concept applies to almost anything of value, including real estate, investment property, stock, mutual fund, or bond.

It is the opposite of capital loss, where the selling price of an asset or investment is less than its purchase price. A short-term or long-term gain may occur depending on the asset holding period and is liable to income taxes. However, the government offers tax exemptionsTax ExemptionsTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more to those reinvesting their capital profits within a specified period.

Key Takeaways

Understanding Capital Gain & its Calculations

Individuals can earn a profit on their assets in two ways. First, when the price of an investment appreciates while they hold it, as it reflects an increase in its value. Second, when they realize an increase in the value of a capital asset or investment during its final sale. In simple words, a capital profit of gain is a difference between the prices (usually higher) at which someone sells and purchases the investment.

capital gain

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A typical example of this is Albert buying a mini-rolling machine for $450 for his workshop. After six years, he sold it for $600 and made a gain of $150.

The financial gain generates an income for the seller and is subject to income tax, referred to as a capital gain tax. The U.S. Internal Revenue System (IRS) imposes a tax on the seller on making a profit. In case of a capital lossCapital LossCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets.read more, the IRS allows the seller to deduct a particular amount, thereby reducing their taxable income for the year.

Understanding capital profit and tax is essential for an individual to make better decisions when selling an asset or investment.

Capital Gains Taxes

Depending on whether the asset’s value increased during the sale or when it was unsold, the gain can be realized or unrealized.

In other words, the profit earned from the asset’s sale is the realized gainRealized GainWhen an asset is sold for a higher price than when it was purchased, it is referred to as a realized gain. Because the seller gains from the transaction, this gain is taxed, however an unrealized gain is not taxable because it is valued at fair market value.read more. The unrealized gain is the difference between the asset’s acquisition price and its current price when it is unsold.

For example, if someone buys $500 worth of shares and sells them for $700, they have realized a gain. If the value of the shares appreciates to $1,000 when it was unsold, the price difference is an unrealized gainUnrealized GainUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal.read more.

Another thing that distinguishes realized from unrealized gain is the taxation rules that apply exclusively to the former. The IRS tax rate applicable to a capital profit depends on how long someone held an asset or investment and their taxable annual income.

Based on the amount of time an item or investment has been held, realized gains are of two types:

#1 – Short-Term Gain

  • It is the profit resulting from the sale of assets or investments held for a year or less. The gain is applicable for regular income taxes up to 37%.
  • Selling a company stock when its price exceeds the purchase price is a perfect example of this.

#2 – Long-Term Gain

  • It is the gain acquired after the selling of assets or investments held for more than a year. It is subject to a tax rate of 0%, 15%, or 20%, lower than regular income taxes.
  • For example, Sandra purchased $14,000 worth of shares in a company in 2010. She sold the shares for $16,500 in 2018, netting a profit of $2,500, which will be subject to a capital gain tax.
Categories of capital gain

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In April 2021, United States President Joe Biden proposed to increase the tax rate on long-term capital profits or gains from 20% to 39.6% for taxpayers earning more than $1 million. It means long-term profits will now incur the same tax rate as short-term gains for ordinary incomeOrdinary IncomeOrdinary income refers to an individual's or business entity's earnings that are taxable at the regular rates. Such earnings include salary, wages, rent received, royalty, commission, interest received, profit, etc. It excludes all incomes with tax deducted at source and capital gain.read more.

The higher tax rate will contribute to the $1.8 trillion stimulus plan American Families Plan, which aims to prolong and improve tax credits for American families.

Examples

Let us look at the examples of capital profit on stocks and bonds and from home sales to understand the concept better:

examples of capital gain

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#1 – Capital Gain On Stocks

Jim is a salaried employee at a software company. In 2019, he purchased some shares in Google, Inc. and sold the same at an increased price in 2021. These shares are the capital assets of Jim, who has been holding them for more than a year. Such shares fetch him a long-term gain when sold at a rate higher than their purchase value.

#2 – Capital Gain From Home Sale

Cindy purchased a lake-view house for $400,000 in Davenport, Florida, in February 2013. She sold the property for $500,000 in June 2018. The lakefront house is a capital asset of Cindy, which resulted in a long-term gain of $100,000 upon sale. Also, this gain will get taxed under the long term capital gains tax.

#3 – Capital Gain On Bonds

In the case of corporate bonds, gain occurs when the investor sells bonds before maturity. For example, Mellisa owns a corporate bond and wants to sell it before its maturity. She receives a small profit more than the purchase price, i.e., a short-term gain. This profit will get taxed under the regular income tax rate. Mellisa’s earnings will be taxed at the long-term gains rate if she sells her bond after a year but before it matures.

Frequently Asked Questions (FAQs)

What are capital gains?

A capital profit or gain refers to the profit earned when the selling price of capital assets like real estate or investments like stocks, mutual funds, or bonds exceeds their purchase price. Since it generates an income for the seller, it is subject to income tax, also known as the capital gain tax. The Internal Revenue Service (IRS) assesses a tax based on the type of gain.

What is long-term capital gain?

Long-term gain is the profit made by selling an asset or investment held for more than a year by the seller. It incurs a lower tax rate than short-term gain.

How capital gains are calculated?

The calculation of capital profit requires subtracting the purchase price of the asset from its selling price. A profit occurs when the asset gets sold for a price higher than the purchase price.

This has been a guide to What is Capital Gain and its Meaning. Here we discuss capital gain understanding and categories, along with their examples. You may also have a look at the following articles to learn more –

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