Understanding Capital Gains Tax: A Comprehensive Guide

Capital gains tax is a tax imposed on capital gains or the profits that an individual makes from selling assets. The tax is only imposed once the asset has been converted into cash, and not when it’s still in the hands of an investor.

For example, assume that an individual owns company sharesStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably., which increase in value each year. In this case, no capital gains tax will be levied just because the shares are appreciating. The only time the capital gains tax will be imposed is when the individual decides to sell the shares for a price higher than their purchase price.

The Basics

In the majority of countries, tax regulations stipulate that capital gain taxes can be levied on investors’ gains. In Canada, for instance, the law requires individuals to pay at least half of their marginal tax rate on profits earned from asset disposal. Similarly, in the United States, both residents and companies incur capital gain taxes on their yearly net capital gains.

Ideally, a capital gain tax is levied on any person or firm that decides to sell an asset for profit. The only exception is for day tradersDay TradingThe main attribute of day trading is that the purchasing and selling of securities occurs within the same trading day., who engage in the buying and selling of assets to make a living. As for the day traders, the profits they make are taxed on the basis of their business revenue rather than capital gains. It’s also important to note that capital gain taxes are levied on different types of assets, whether they are stocks, bonds,BondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period. or real estate property.

Short-term vs. Long-term Capital Gains

One thing that firm owners need to keep in mind is that assets are not taxed equally, especially when it comes to investment incomes. The amount of tax levied will depend on the asset’s holding period.

Essentially, there are two kinds of profits that a company can make when it disposes of an asset: long-term and short-term capital gains.

Long-term capital gains arise when investments or other assets are held for a period of more than 12 months. In contrast, short-term gains are realized on investments held for less than 12 months. Take the example of a shareholder who buys 150 shares of stock at a price of $20 per share. Six months down the line, he decides to sell them at a price of $25 per share; hence making a profit of $750. The profit is classified under short-term capital gains. Differentiating between these capital gains is crucial because the two are taxed differently.

Reducing Capital Gains Taxes

Regardless of the kind of asset that individual plans to sell, there are a few methods used to reduce the capital gains tax incurred. They include:

1. Waiting longer than one year before selling

As already explained, once a company sells an asset, it can make long-term or short-term capital gains. One of the benefits of capital gains that fall under the long-term status is that they attract lower capital gains tax rates. As such, one of the ways to reduce the tax that one is liable for is to hold assets for a longer period. Here is a breakdown of how capital gains tax is levied:

• Marginal rates ranging between 10% and 15% pay a rate of 0%
• Marginal rates that range from 25% and 28% to 35% attract a tax of 15%
• Marginal rates of 39.6% pay a capital gains tax of 20%

For example, if an individual in the 28% tax bracket decides to sell stock that amounts to a capital gain of $5,000, the difference in tax based on short- and long-term gain is:

Short-term gain taxed at 28%: $5,000*0.28 = $1,400

Long-term gain taxed at 15%: $5,000*0.15 = $750

2. Sell when your income is low

As seen in the outline above, the long-term capital gains rate is determined by one’s marginal tax rate, which is then dependent on an individual’s incomeRemunerationRemuneration is any type of compensation or payment that an individual or employee receives as payment for their services or the work that they do for an organization or company. It includes whatever base salary an employee receives, along with other types of payment that accrue during the course of their work, which. That said, disposing of long-term capital gain assets during “lean” years can help reduce the capital gains tax.

Situations that may cause a decline in an individual’s income include approaching retirement period, quitting, or loss of employment. Selling assets at such times can minimize the amount of capital gains tax levied.

3. Timing capital losses with capital gains

In any given period, capital losses can be used to offset capital gains. Let’s assume that an individual owns two types of stocks: A and B. When he sells stock A, he makes a profit of $60, but when he sells stock B, he makes a loss of $30. His net capital gain is the difference between his capital gain and loss: $30.

By using capital losses in the years where he made capital gains, an individual can lower his capital gains tax significantly. Even though individuals are required to report all their capital gains, the tax to be levied is computed on the net capital gain.

Final Word

A capital gain occurs when the sales price received from disposing of an asset is higher than its purchase price. A capital gains tax is that tax imposed on the profits made from such sales. However, there are a few tricks that can be employed to lower the amount of capital gains tax imposed. They include holding assets for a longer period before selling them, disposing of assets when their income is low, and using capital losses to offset the gains.

More Resources

Thank you for reading CFI’s guide to the capital gains tax. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Ad Valorem TaxAd Valorem TaxThe term “ad valorem” is Latin for “according to value,” which means that it is flexible and depends on the assessed value of an asset, product or service.
• Available For Sale SecuritiesAvailable for Sale SecuritiesAvailable for sale securities are the default categorization of securities that companies decide to invest in for the purposes of benefiting their financial position. Unlike trading securities, available for sale securities are not bought or sold for the sole purpose of realizing a short-term capital gain.
• Deferred Tax Liability/AssetDeferred Tax Liability/AssetA deferred tax liability or asset is created when there are temporary differences between book tax and actual income tax.
• Wash SaleWash SaleA wash sale is categorized when an investor sells a stock or security and repurchases the same or a substantially identical security within 30 days of the sale. The US Internal Revenue Service (IRS) introduced the 61-day wash sale rule to prevent investors who hold unrealized losses from benefiting