Capital Gains and Losses

Investors receive two types of income: ordinary income and capital gains. Ordinary income includes dividends and interest you receive. You have a capital gain when you sell a capital asset for a profit. Any asset you hold as an investment (stocks, bonds, real estate, for example) is a capital asset.

Note: Capital assets do not include supplies (such as paper and pens) or inventory (anything you regularly sell to customers in your business). Investment assets such as stocks and bonds are not considered inventory — even if you regularly sell them — unless you're a securities dealer.

Of course you can also lose money when you sell a capital asset: a capital loss.

Advantages of Capital Gains

Capital gains are better than ordinary income for two reasons. First, you don't pay tax on a capital gain until you sell the asset. Normally you can choose whether to sell sooner or later, so you control the timing of your gain or loss. For example, you can decide to sell late in December or early in January, depending on which year you want to report your gain or loss. Generally speaking, you don't have that kind of choice with ordinary income, such as interest and dividends.

Capital gains have another big advantage over ordinary income: they're taxed at special rates. To qualify for these rates you must have long-term capital gains. Short-term capital gain is taxed at the same rates as ordinary income.

Special Rates for Long-Term Capital Gain

A capital gain or loss is long-term if you held the asset more than one year (at least a year and a day) before you sold it. At that point you're entitled to a special capital gain rate. In most cases the rate will be 20% (10% if the gain falls within the 15% bracket). There are exceptions for certain types of assets.

The 20% (or 10%) rate should always produce some savings. If your tax bracket for ordinary income is 10% or 15%, the rate on this category of capital gain is 10%; if your ordinary tax bracket is 28% or higher, the rate on this category of capital gain is 20%.

Measuring Capital Gain

Your capital gain from a sale is measured by the difference between the amount realized in the sale and your basis in the asset you sold. Roughly speaking, the amount realized is what you received on the sale — usually measured by the sale price minus the brokerage commission. Your basis is based on your cost (usually the purchase price plus the brokerage commission) but may be adjusted as a result of various events. For example, if your stock splits while you own it, the basis splits, too.

Example: You buy 100 shares of XYZ at $35, paying $3,500 plus a brokerage commission of $40. Your basis is $3,540. Later, you sell when the stock is at $39. You receive $3,900 minus a brokerage commission of $40, so your amount realized is $3,860. Your capital gain is $3,860 minus $3,540, or $320.

If your basis is greater than the amount realized, you have a capital loss.

What About Capital Losses?

Capital losses are used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your ordinary income — up to a limit of $3,000 in one year. If your overall capital loss is more than $3,000, the excess carries over to the next year. In other words, you treat the extra portion as if it were an additional capital loss in the following year.

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