If you make a profit when you sell a capital asset—from something like selling a stock or selling real estate—the gains can be subject to the capital gains tax.
To calculate a capital gain, you subtract how much you originally paid for the asset from its final sale price.
How your gains are taxed depends on how long you’ve held the asset and how much money it made.
When you hear the term “capital gains tax,” you may think it’s something only wealthy investors need to worry about. But any capital asset that is sold for a profit can be subject to capital gains tax.
If you’re a beginner investor or are planning to sell a house, you should definitely understand capital gains and the impact they can have on your financial life. The fact that you’ve potentially got capital gains might be a positive financial milestone, but it’s important to understand the potential taxes that come with them.
So, what is the capital gains tax? Read on to understand some of the basic terms around this topic.
What is a capital asset?
Before we get into capital gains, it’s important to understand some related terms. Let’s start with defining a capital asset.
A capital asset is property you own for investment or personal purposes. This can include anything from stocks and bonds to real estate and cars. When you sell a capital asset, you’ll get either a capital gain or a capital loss (unless you bought and sold it for the exact same amount).
The capital gain or capital loss usually depends on “cost basis,” which is generally the amount you spent to buy it compared to the amount you sold it for. While this is the guideline, circumstances such as the death of the owner or significant upgrades to real estate can also factor in.
What is a capital gain vs. a capital loss?
A capital gain is the profit you make by selling an investment (such as stocks or bonds), real estate or personal property. To calculate a capital gain, subtract the cost basis of the investment from its final sale price. If the resulting number is positive, then you have realized a gain, and you must pay taxes on that profit.
If the resulting number is negative, then you have realized a capital loss, which is not taxed. In fact, a capital loss can offset capital gains and up to $3,000 of ordinary income and reduce your tax liabilities for the year the loss was realized.
What are realized vs. unrealized gains?
If you buy an investment and the value of that investment increases—but you’re still holding onto it—then you have “unrealized” gains. In other words, your gains aren’t “realized” until you actually sell your investment and convert those profits into cash. Some people call an unrealized gain a “paper gain.” These paper gains or unrealized gains are not taxed, but realized gains are.
As you think about this, keep in mind that any capital asset that is sold for a profit can be subject to the capital gains tax. (And don’t get confused by banks’ unrealized losses, such as the high-profile losses at Silicon Valley Bank. We’re focused on capital gains and losses for individual tax filers, not banks or other businesses.)
The capital gain or capital loss is determined by comparing your "basis" (the amount you paid for a capital asset and any adjustments to your basis, e.g. from the death of the original owner or from upgrades to real estate), to the amount you sold it for.
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What is the capital gains tax?
The capital gains tax is the tax you owe on any realized gain that results from selling a capital asset. Capital gains and losses come in two varieties: short-term and long-term, which are defined by how long you held the investment prior to selling it.
Short-term capital gains are typically taxed at a higher rate than those realized in the long term. That’s because the government is trying to encourage investors to hold onto their investments for longer periods of time, as short-term buying and selling can have a destabilizing effect on the market.
What counts as a short-term capital gain?
A short-term capital gain is any profit that you realize from an investment that you have held for one year or less. For example, if you buy shares in a company and sell them for a profit within one year of the purchase date, you will be required to pay the short-term capital gains tax rate on that profit. Short-term capital gains are taxed at the same rate as your “ordinary income,” which includes things like wages, tips, bonuses and interest. For the 2024 tax year, ordinary income tax rates range from a low of 10 percent to a high of 37 percent.
What counts as a long-term capital gain?
A long-term capital gain is any profit that you realize from an investment that is held for more than one year. Say you purchase shares in a company and hold them for 10 years. If you sell them for a profit, you will pay the long-term capital gains tax rate on that income. Currently, long-term capital gains are taxed at lower rates than short-term gains.
The long-term capital gains tax rate that you will be charged on the money you make by selling an investment will depend mainly on your income level and your filing status (e.g., single filer, married couple filing jointly, head of household, etc.). For most situations, the current rates are 0 percent, 15 percent or 20 percent. You will likely need to include a Schedule D (Form 1040) as part of your tax return.
Download your complimentary copy of Northwestern Mutual’s Quick View Tax Guide. This guide can help ensure you understand your applicable federal income tax rates and that you are taking advantage of every deduction and credit available to you.
What sales qualify for the capital gains tax?
Still not sure whether you need to worry about paying capital gains taxes? Here are some quick guidelines:
- If your only investments are in the form of contributions you are making to a retirement account like a 401(k), 403(b) or IRA, then you don’t need to worry about the capital gains tax. These tax-advantaged accounts allow your investments to grow tax-deferred until you use them in retirement, at which point any disbursements will be taxed at ordinary income tax rates. And you generally will not be required to pay taxes on distributions from a Roth 401(k) or Roth IRA because your contributions to those accounts were taxed before you invested them.
- If you have made investments outside a retirement account, be aware of their tax implications. Understand the difference between short- and long-term capital gains, and plan the sale of those investments accordingly. You may be able to use some of your investment losses to offset your gains in a strategy known as tax-loss harvesting, but you should consult a tax advisor to see if it makes sense for you.
- If you are considering selling something (an investment or valuable piece of property) to realize a capital gain, it’s important to understand how this action could affect your tax situation. Again, consult a tax advisor to make sure this makes sense for your personal financial situation.
- If you are a retiree or senior, be aware that there is no current age limit for capital gains taxes. Likewise, there is no current exception for people on Social Security.
How does the capital gains tax work for home sales?
If you’re selling your primary residence, and you’ve lived there for at least two of the previous five years, the rules are a little different. You’ll get to exclude $250,000 of your capital gains on the home sale. If you’re married and filing jointly, the exclusion bumps up to $500,000.
For example, think about a married couple who files jointly and bought a house several years ago. Their kids are out of the house and the couple plans to downsize and move into an apartment. They sell the house for $750,000 more than they bought it for, so their gain is $750,000 minus the $500,000 exclusion, which equals $250,000. They need to pay capital gains tax on this $250,000 of gain.
How do I avoid capital gains tax?
In short, avoiding any sales will prevent being subject to capital gains tax. However, avoiding sales for this reason may not make the most sense for your financial situation. There may be some situations when selling your asset and paying the tax may still be the favorable move. That’s why it’s best to work with a financial advisor and tax professional when making investment decisions to determine what makes the most sense for you.
A Northwestern Mutual financial advisor can help you see how your investments work with other important financial pieces of your puzzle for the most growth down the line.
This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.
As an attorney in Sophisticated Planning Strategies, I work with Northwestern Mutual financial advisors as they help clients achieve financial security.