Long-term & short-term capital gain: do you know what they are?

Understanding the differences between long-term and short-term capital gains tax can lead to substantial savings and smarter investment choices. This blog post explores the nuances of short-term versus long-term capital gains tax, offering practical strategies and tips to reduce your tax burden. Whether you are an experienced investor or beginning to create your portfolio, this article will provide you with the necessary insights to maximize your investment returns.

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What are long-term capital gains?

Long-term capital gains refer to the profits earned from selling assets that have been held for more than one year. These assets can include stocks, bonds, real estate, and other investments. A notable feature of long-term capital gains is that they are taxed at a lower rate compared to short-term capital gains (profits from assets held for one year or less) and ordinary income.

The tax rate for long-term capital gains in the United States varies based on your income level, with the lowest rate being 0% for low-income individuals and the highest rate being 20% for high-income individuals.

What are capital assets for tax purposes?

For tax purposes, capital assets encompass a broad spectrum of investments, including stocks, bonds, real estate, and collectibles. Section 1221 of the IRS Code defines what constitutes a capital asset. In this context, a capital asset is any property owned by the taxpayer, like stocks, bonds, or real estate. However, it excludes property primarily held for sale to customers in the normal course of the taxpayer's business, such as inventory.

How to calculate capital gains tax?

A capital gain arises when a taxpayer sells a capital asset for an amount exceeding its adjusted basis. Conversely, a capital loss occurs when the sale price is less than the adjusted basis of the asset. To calculate the capital gains tax, one must establish the asset's holding period, classify the gains as either short-term or long-term, and use the corresponding tax rate. The calculation involves subtracting the asset's original cost from the selling price.

Capital Gains Tax Rates

Capital gains tax is imposed on the profit made from selling certain assets, like stocks, bonds, real estate, or other investments. The rate of capital gains tax varies based on several factors, such as the seller's income level, the asset type, and how long the asset was owned. Individuals in the lower income brackets (10% and 15%) are subject to a 0% long-term capital gains tax rate, while those in the highest bracket (37%) face a 20% rate. Meanwhile, individuals in the higher brackets (25%, 28%, 33%, and 35%) have a long-term rate of 15%.

What is the difference between long-term and short-term capital gains?

The key distinction between long-term and short-term capital gains taxes is the duration for which the asset is held and the corresponding tax rates. Short-term capital gains taxes apply to profits from selling assets held for a year or less, while long-term capital gains taxes apply to profits from selling assets held for more than a year. This difference is significant as it can greatly affect your tax burden.

For example, selling an asset after holding it for over a year subjects you to long-term capital gains taxes, which typically have lower rates than short-term taxes. Conversely, if you sell an asset within a year of buying it, you'll incur short-term capital gains taxes, taxed at the same rate as your regular income.

Grasping the nuances between long-term and short-term capital gains is essential for effective investment and tax liability management.

Factors influencing short-term capital gains tax rates and liability

The capital gains tax rate depends on the taxpayer's present tax bracket, the time the asset was held, and the level of the taxpayer's income.

Income Level

As mentioned earlier, see above tables, the short-term capital gains tax rate is directly proportional to the taxpayer’s income level. Short-term gains are taxed at the taxpayer’s highest marginal tax rate or regular income tax bracket, ranging from 10% to 37%. Consequently, a higher income level can result in a higher short-term capital gains tax liability.

Holding Period

The duration for which an asset is held significantly affects the liability for short-term capital gains tax; assets held for shorter periods incur higher taxes. As previously mentioned, holding an asset for over a year makes it eligible for the lower long-term capital gains tax rates. Conversely, assets held for one year or less fall under the short-term capital gains tax, which is levied at the same rate as regular income.

Limit on the Deduction and Carryover of Losses

Individuals can deduct a maximum of $3,000 in capital losses against ordinary income per year. If capital losses are greater than capital gains, the deductible amount to reduce income is the lesser of $3,000, or $1,500 for those married filing separately, or the total net loss reported on line 16 of Schedule D. Should your net capital loss exceed this threshold, you have the option to carry over the loss to subsequent years.

Strategies to Reduce Short-Term Capital Gains Tax

Several strategies exist to avoid capital gains taxes and lower your capital gains tax burden. These include timing the sale of assets, using capital losses, and investing in tax-advantaged accounts. Employing these strategies can assist in reducing your capital gains tax liability and maximizing your investment returns.

Timing Asset Sales

The timing of asset sales can significantly affect your short-term capital gains tax liability. By retaining your assets for over a year before selling, you may be eligible for long-term capital gains tax rates, which are typically lower than short-term rates. This strategy can lead to considerable tax savings and assist in maximizing your investment returns.

Utilizing Capital Losses

Leveraging capital losses is a strategic approach to decrease your short-term capital gains tax. Capital losses arise when a capital asset is sold for a price lower than its original purchase price. These losses can offset capital gains, which may reduce your total tax obligation. As the year-end approaches, consider disposing of assets that have unrealized losses to counterbalance the capital gains incurred in the current year.

Investing in Tax-Advantaged Accounts

Investing in tax-advantaged accounts like IRAs and 401(k)s can be beneficial for deferring or avoiding capital gains taxes. These accounts enable your investments to accrue either tax-free or tax-deferred, based on the account type. For instance, distributions from traditional IRAs and 401(k)s are taxable upon withdrawal in retirement. Realized capital gains within certain retirement accounts do not incur capital gains taxes or other taxes until distributions are made.

Reporting Capital Gains on Your Tax Return

To report capital gains on your tax return, Schedule D and Form 8949 are required to detail gains and losses and calculate the net capital gain or loss. The following subsections will guide you through the usage of these forms and offer recordkeeping advice for precise reporting.

Schedule D and Form 8949

Schedule D is used to report gains or losses realized from the sale of capital assets, while Form 8949 is used to report sales and exchanges of capital assets and provides details about each stock trade made during the year. These forms are essential for accurately reporting your capital gains and losses and calculating your net capital gain or loss, which determines your overall tax liability.

Recordkeeping Tips

Accurate recordkeeping is vital for correctly reporting capital gains and losses on tax returns. Keeping detailed records of the sale price, purchase price, commissions, fees, and the basis of each asset aids in calculating the net capital gain or loss. Moreover, it's imperative to keep these records for a minimum of five years following the sale or disposal of an asset to provide necessary documentation in the event of an IRS audit or inquiry.

How We Can Help You

At H&CO, our experienced team of tax professionals (CPAs) understands the complexities of income tax preparation and is dedicated to guiding you through the process. With a personalized approach, we help you navigate US and international income tax laws, staying up to date with the latest changes.

With offices in Miami, Coral Gables, Aventura, and Fort Lauderdale, our CPAs are readily available to assist you with all your income tax planning and tax preparation needs. To learn more about our accounting firm services take a look at our individual tax services, business tax services, international tax services, expatriate tax services, SAP Business One, entity management, human capital, and audit and assurance services.  

Frequently Asked Questions

What distinguishes short-term capital gains from long-term capital gains?

Short-term capital gains are generated from the sale of assets held for one year or less, while long-term capital gains arise from the sale of assets held for more than one year.

How are short-term capital gains taxed?

Short-term capital gains are typically taxed at the individual's ordinary income tax rates, which can range from 10% to 37% based on their income level.

How are long-term capital gains taxed?

Long-term capital gains are subject to preferential tax rates, with rates of 0%, 15%, or 20%, depending on the individual's taxable income and filing status.

What is the holding period requirement for an investment to qualify as a long-term capital gain?

To be eligible for long-term capital gains tax rates, an investment must be held for over one year from the date of purchase before it is subject to capital gains taxes.

How do I avoid taxes on short-term gains?

To sidestep taxes on short-term gains and reduce capital gains taxes, consider investing in tax-exempt or tax-deferred accounts, adopting a long-term investment strategy, minimizing capital gains taxes, and making contributions to retirement accounts. By doing so, you can earn money from your investments while avoiding the hefty taxes that come with short-term gains.