Every year when tax season rolls around, investors quickly become familiar with capital gains and losses. What is a capital gain or loss? In short, it’s the difference between what you bought an investment for and what you sell it for. If the result is positive, it’s a gain. If the result is negative, it’s a loss.
The implication of capital gains and losses is largely related to taxes. The realization of capital gains or losses only occurs after you sell an asset, which triggers the taxable event. It’s in the best interest of investors to understand how these gains or losses affect them financially, and strategies to maximize gains while minimizing losses.
Realizing Capital Gains and Losses
All portfolio gains and losses are “unrealized” until the investor sells the asset. This is because exiting a position “locks in” the new value. As long as you hold an asset, it can continue to gain or lose value relative to the original price paid. For this reason, gains and losses aren’t capital gains and losses until the sale of the asset, when they’re “realized.” Here’s an example:
Gustaf buys 100 shares of ABC Company for $5 per share, for a total investment of $500. After two years, the share price is now $12 and Gustaf’s holdings are worth $1,200. He has unrealized gains of $700. He decides to realize those gains and sells his entire holdings in ABC Company. The sale triggers a taxable event for the $700 in now-realized gains.
In this example, the same would be true if the share price fell. Instead of locking in gains, the investor would lock in a loss. The sale would still trigger a taxable event, but instead of paying capital gains tax, there would be a capital loss offset. More on taxation below.
Short-Term vs. Long-Term Gains and Losses
Capital gains and losses fall into one of two categories: short-term or long-term. This distinction has implications for taxation, as well as how they’re treated as investments:
- Short-term capital gains and losses are held for less than one year.
- Long-term capital gains and losses are held for more than one year.
This distinction is most important for capital gains, since tax rates differ for short- and long-term realized gains.
How Are Capital Gains Taxed?
Realizing capital gains means understanding how they’re taxed. Specifically, investors need to be aware of when they realize gains. Short- and long-term capital gains face different tax rates.
Long-Term Capital Gains
Depending on your filing status, tax for long-term capital gains can range from 0% to 20%. Here’s a look at the effective tax rates capital gains (2021) based on filing status and income:
| Filing status | 0% rate | 15% rate | 20% rate |
| Single | Up to $40,000 | $40,000 to $441,450 | +$441,450 |
| Head of household | Up to $53,600 | $53,600 to $469,050 | +$469,050 |
| Married filing jointly | Up to $80,000 | $80,000 to $496,600 | +$496,600 |
| Married filing separately | Up to $40,000 | $40,000 to $248,300 | +$248,300 |
Short-Term Capital Gains
Short-term capital gains face much higher tax rates than long-term gains. They range from 10% to 37% depending on filing status and income. Here’s a look at effective tax rates (2021):
| Filing status | 10% | 12% | 22% | 24% | 32% | 35% | 37% |
| Single | Up to $9,875 | $9,876 – $40,125 | $40,126 – $85,525 | $85,526 – $163,300 | $163,301 – $207,350 | $207,351 – $518,400 | +$518,400 |
| Head of household | Up to $14,100 | $14,101 – $53,700 | $53,701 – $85,500 | $85,501 – $163,300 | $163,301 – $207,350 | $207,351 – $518,400 | +$518,400 |
| Married filing jointly | Up to $19,750 | $19,751 – $80,250 | $80,251 – $171,050 | $171,051 – $326,600 | $326,601 – $414,700 | $414,701 – $622,050 | +$622,050 |
| Married filing separately | Up to $9,875 | $9,876 – $40,125 | $40,126 – $85,525 | $85,526 – $163,300 | $163,301 – $207,350 | $207,351 – $311,025 | +$311,025 |
State-Level Capital Gains
Some states tax capital gains, while others don’t. Investors need to be mindful of where they file their taxes when it comes to claiming capital gains. It usually depends on how the state taxes income. States with no income taxes tend not to tax capital gains:
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Net Capital Gain
When tax season comes around and investors need to report realized capital gains and losses, the IRS concerns itself with net capital gain. This is the sum total of all capital gains and losses realized during the previous period. This is to say that capital losses offset capital gains. For example:
Tom sells his stake in ABC Company, which realizes $10,000 in capital gains. He also sells his stake in XYZ Company, which results in a capital loss of $5,000. His net capital gain is $5,000.
In some cases, capital losses will actually outweigh capital gains. Investors with negative net capital gain can use up to $3,000 in losses a year to offset ordinary income on federal income taxes—and carry over the rest forward.
The Bottom Line on Capital Gains and Losses
Every investor will face the prospect of capital gains and losses—you need to realize them eventually! The best thing any investor can do is to understand the tax implications of a taxable event. What’s your net capital gain? Are your gains short- or long-term? What tax bracket do you fall into? Do you live in a state with income tax? Is there an opportunity to offset capital gains with capital losses? Understand these implications before you exit a position and realize the capital gains or losses. This is even more important for retirees because your investments are vital to your daily needs. To learn how you can maximize your investment opportunities in retirement, sign up for the Wealthy Retirement e-letter below!