The Difference Between Long-Term vs. Short-Term Capital Gains
New investors may not be familiar with the terms: long-term capital gains and short-term capital gains.
Even experienced investors may have heard these terms without completely understanding them.
Thankfully, they aren’t too difficult to understand after you read through how they work.
The best part:
Understanding these terms could save you money on your taxes.
Here’s what you need to know about short-term and long-term capital gains in general. As always, consult a tax professional about advice specific to your situation.
What Are Capital Gains?
Capitals gains are the gains you receive when you sell a capital asset for more than your adjusted basis in that asset.
There are a lot of tax terms in there, so let’s break them out.
According to the IRS, “Almost everything you own and use for personal or investment purposes is a capital asset.”
To make things crystal clear, capital assets include possessions such as houses and cars as well as investments such as stocks, bonds, real estate and mutual funds.
Your basis in an asset is generally the price you paid for that asset. If you buy a share of stock for $100, your basis is $100.
Adjusted basis is your basis after accounting for specific adjustments. These adjustments vary depending on your type of asset and the specific adjustments that may be made to it.
For example, the adjusted basis of a rental property would be less than your original basis in most cases. This is because depreciation decreases the basis.
Stocks and other investments may have adjusted basis, but it happens in more rare cases.
For instance, an adjusted basis calculation may need to be done if you received stock as part of an inheritance.
To learn all of the details about adjusted basis, read this IRS publication.
Long-Term Capital Gain
When you sell an asset above the basis you have in it, you have a gain.
If you held that asset for more than one year before selling it, that gain is said to be a long-term capital gain.
For example, let’s say you bought a share of Company A on January 1, 2015 at $100. You sold the share of stock on January 1, 2020 for $245. In this case, you’d have a long-term capital gain of $145 as long as no basis adjustments are required.
Short-Term Capital Gain
A short-term capital gain occurs when you sell an asset for more than your basis in it but you’ve only held the asset for a year or less.
Holding an asset for exactly one year, but not over one year, results in a short-term capital gains treatment.
An easy example of short-term capital gains is the trades a day trader makes.
If you bought a share of stock at 10:00 am this morning for $50 and sold it at 2:00 pm on the same day for $51, you’d have a $1 short-term capital gain.
Why Does it Matter? Capital Gains Taxes
So why does it matter that there is a difference between short-term and long-term capital gains?
Capital gains are taxed using different tax rates based on the type of gain you have. Long-term capital gains generally receive favorable tax treatment.
You typically pay less taxes on asset sales that qualify for long-term capital gains treatment. Here are what the current tax rates are as of 2020.
Short-term capital gain tax rates
If you don’t hold your asset for over a year, you have to pay short-term capital gains taxes.
In some cases, you may not be able to hold on to an asset long enough to reach the long-term capital gains time frame.
For instance, you may have to sell an investment to pay a bill. If a company starts performing poorly, you may want to sell as soon as possible to avoid a massive loss if things turn for the worst case scenario.
Your short-term capital gains work just like ordinary income taxes. How much you pay will depend on your marginal income tax bracket.
The tax rates from brackets are currently:
The taxable income ranges depend on your filing status which could be:
- Married filing jointly
- Married filing separately
- Head of household
If your gains push you into higher income tax brackets, you’ll only pay the higher tax rate on the marginal, or additional, income that falls above the cut-off.
Thankfully, you don’t pay the higher tax rate on the entire gain.
Long-term capital gains tax rates
If your asset sale qualifies for long-term capital gains, you don’t have to pay ordinary income taxes. Instead, you pay the long-term capital gains tax rate.
The best treatment happens if your taxable income is below $78,750. In this case, your long-term capital gains tax rate may be 0% depending on your specific situation.
If your long-term capital gains push your taxable income above $78,750, only the income that falls below the limit will be taxed at 0%.
For the vast majority of people, the highest usual long-term capital gains tax rate is 15%. For high income individuals, a higher rate of 20% exists.
You have to earn over the following amounts to end up in the 20% long-term capital gains tax rate depending on your filing status:
- $244,425 for married filing separately
- $434,550 as a single individual
- $461,700 for head of household
- $488,850 for a married filing jointly or qualified widow(er)
These lower tax rates could save you considerable amounts of money paid in taxes if you’re able to hold on to your capital assets for over one year.
When it comes to investing, short and long-term capital gains usually pop up most often in taxable investment accounts.
Other investment account types may not take these special tax rates into account.
To make things even more complicated, certain types of assets have different capital gains tax rates than usual.
You aren’t always going to have gains, either. Losses can offset gains in a specific fashion. Here’s what you should know about these issues.
Assets with different capital gains rates
Certain types of capital gains have higher long-term capital gains tax rates. These situations aren’t as common, but they do exist.
According to the IRS, these include:
- Taxable part of gains from section 1202 qualified small business stock sales (up to 28%)
- Net taxable gains from collectibles which include art and coins (up to 28%)
- Unrecaptured section 1250 gains from selling section 1250 real property (up to 25%)
Offsetting capital gains with capital losses
You won’t have only gains.
You can also have short and long-term capital losses.
Capital gains and losses offset (or cancel) each other out in the following ways.
Short-term losses offset short-term gains. Long-term losses offset long-term gains.
After this exercise is done. Long-term gains can offset short-term losses. If your situation is the other way around, it also works. Short-term gains can be offset by long-term losses.
If you end up with net capital gains of the long-term variety, you pay long-term capital gains tax rates.
Net short-term capital gains result in paying ordinary income tax rates.
If you have a net capital loss, up to $3,000 of it in most cases can lower your taxable income.
This presents a unique opportunity to use net long-term capital losses to offset ordinary income taxes rather than long-term capital gains which are taxed at a lower tax rate.
Any capital losses in excess of $3,000 are carried forward. They can be used to offset gains of up to $3,000 of ordinary income on future years’ tax returns.
Tax-advantaged accounts gave their own rules
Another exception is tax-advantaged accounts.
The rules of a tax advantaged account will tell you exactly how your income from that account will be taxed.
For instance, qualified Roth IRA withdrawals after age 59.5 are income tax free if you meet the qualifications.
Traditional IRA distributions after age 59.5 require you to pay taxes. Unfortunately, the rules specify you must pay your ordinary income tax rate on this income, not the capital gains tax rates.
Check the rules of your specific tax-advantaged account to see how the income will be taxed when you withdraw funds from the account.
The way the capital gains system incentivizes people to hold onto their capital assets for the long-term.
If you do and your asset qualifies, you’ll be rewarded with the long-term capital gains rates instead of the higher short-term capital gains rates.
As always, consult a tax professional for questions about your specific situation. Each person’s circumstances are unique.
The tax laws can be complicated and, based on your situation, may not work as you think. A tax professional can look at your situation and let you know how it will work under the current tax rules.