Capital Gains Taxes Explained: Short-Term vs. Long-Term

When you sell an investment, such as a stock, bond, mutual fund or real estate, for more than you paid, the profit is called a capital gain, and it may be subject to tax. Understanding how capital gains are taxed can help you make smarter decisions about when to sell and how to manage your investments. Tax rules change over time, so check irs.gov or consult a tax professional for current details.

What a capital gain is

A capital gain is the profit you make when you sell a capital asset for more than its cost basis. Capital assets include most investments, such as stocks, bonds, mutual funds and ETFs, as well as real estate and personal property like collectibles.

A capital gain is only realized, and generally taxable, when you sell. If your investments increase in value but you don’t sell, you have an unrealized gain, which isn’t taxed. This means you can often control when you pay capital gains taxes by choosing when to sell.

Short-term versus long-term capital gains

How long you hold an investment before selling determines how the gain is taxed.

Short-term capital gains come from investments held one year or less. They’re generally taxed at your ordinary income tax rate, the same rate as your wages, which can be relatively high depending on your income.

Long-term capital gains come from investments held more than one year. They’re generally taxed at lower rates of 0%, 15% or 20%, depending on your taxable income and filing status. Many middle-income taxpayers pay 15%, while some lower-income taxpayers may qualify for the 0% rate.

The difference between short-term and long-term rates can be substantial, which is why holding investments for more than a year can lead to meaningful tax savings.

Some higher-income investors may also owe the 3.8% net investment income tax on capital gains and other investment income above certain income thresholds. Certain types of assets, such as collectibles, may be taxed at different rates.

How your gain is calculated

Your capital gain is generally the sale price minus your cost basis. Your cost basis is usually what you paid for the investment, plus certain costs like commissions or fees.

For investments bought at different times, such as through regular contributions or reinvested dividends, your cost basis can become complicated. Reinvested dividends increase your cost basis, since you already paid tax on those dividends. Keeping records of purchases helps ensure you don’t pay more tax than necessary.

Brokers are generally required to track and report cost basis for many investments and report it to you and the IRS on Form 1099-B. Many brokers let you choose a cost basis method, such as first in, first out, or specific identification of which shares to sell, which can affect your taxable gain.

Capital losses

If you sell an investment for less than your cost basis, you have a capital loss. Capital losses can be valuable for tax purposes.

Losses can generally offset capital gains, reducing your taxable gains. If your losses exceed your gains, up to $3,000 of excess losses, or $1,500 if married filing separately, can generally be deducted against other income, like wages, each year. Any remaining losses can be carried forward to future years indefinitely.

Some investors deliberately sell investments at a loss to offset gains, a strategy called tax-loss harvesting. They often replace the sold investment with a similar one to maintain their market exposure.

However, watch the wash-sale rule, which disallows the loss if you buy a substantially identical investment within 30 days before or after the sale. The disallowed loss is generally added to the cost basis of the new investment, deferring rather than eliminating the benefit.

Ways to manage capital gains taxes

Hold investments longer than a year when it fits your plan, to qualify for lower long-term capital gains rates.

Use tax-advantaged accounts like 401(k)s and IRAs, where buying and selling generally don’t trigger capital gains taxes. In traditional accounts, withdrawals are taxed as ordinary income, while qualified Roth withdrawals are tax-free.

Be thoughtful about selling in taxable accounts. Consider the tax impact before selling, especially for investments held less than a year.

Consider gains and losses together before year-end. Reviewing your portfolio before December can help you identify opportunities to offset gains with losses.

Consider your income in a given year. If you expect lower income in a particular year, such as early retirement, selling investments with gains in that year may qualify you for a lower capital gains rate, possibly even 0%.

Donate appreciated investments to charity. Donating appreciated stock held more than a year directly to a qualified charity may allow you to deduct its fair market value, subject to limits, while avoiding capital gains taxes on the appreciation.

Inherited investments may receive a step-up in basis to their value at the original owner’s death, which can significantly reduce capital gains taxes for heirs.

Special rules for home sales

Special rules may let you exclude some or all of the gain on the sale of your main home. If you meet ownership and use requirements, generally owning and living in the home as your main residence for at least two of the five years before the sale, you may be able to exclude up to $250,000 of gain, or $500,000 for married couples filing jointly. Check IRS rules for details.

Get help

Capital gains taxes can become complex, especially with large portfolios, real estate or business assets. A tax professional can help you plan sales, harvest losses and minimize taxes as part of your overall financial strategy.