Capital gains tax for investors

The capital gains tax is the federal levy on the profit you realize when you sell an investment for more than you paid for it. The tax rate depends on how long you held the asset: gains on assets held longer than a year receive preferential rates, while gains on assets held under a year are taxed as ordinary income. Tax treatment varies by jurisdiction; this entry describes US federal treatment.

How capital gains arise

You incur a capital gain when you sell an investment—a stock, bond, or real estate—for more than your cost basis. The gain is the difference between your sale price and your adjusted purchase price. Until you sell, the gain is “unrealised”; once you sell, it becomes taxable. You do not pay tax on unrealised gains no matter how high they climb—only when you crystallise them by selling.

A capital loss occurs in the reverse: when you sell an asset for less than you paid. Losses can offset gains and, within limits, your ordinary income, reducing your total tax bill.

Short-term vs. long-term

The holding period—how long you owned the asset before selling—determines the tax rate applied:

Short-term capital gains are profits on assets held one year or less. These are taxed at your ordinary marginal tax rate, which can be as high as 37% federally. For most investors, short-term gains are the least tax-efficient way to make money.

Long-term capital gains are profits on assets held longer than one year. The federal tax rate is preferential: 0% for low-income earners, 15% for most middle and upper-middle-income earners, and 20% for the highest earners. State taxes, plus the 3.8% net investment income tax, may apply on top.

The one-year threshold is crossed at the moment of sale on the anniversary of your purchase. Buy on January 15, 2024; sell on January 15, 2025 or later, and it counts as long-term.

Why the preferential rate exists

Long-term capital gains receive special treatment because policymakers believe it encourages capital formation and long-term investment. The lower federal rate is meant to offset the annual drag of inflation and the cost of deferring consumption. For investors, it is simply a tax gift for patience: hold longer, pay less.

Realizing vs. not realizing

One of the most powerful tools in tax planning is the ability to defer gains indefinitely by not selling. An investor with a stock worth three times its purchase price pays no tax until that moment of sale. This is sometimes called the “step-up-in-basis loophole”—see stepped-up basis at death—because it allows you to defer taxation until death, at which point heirs receive a reset.

For long-term investors, this is often the best tax strategy: buy, hold, and reinvest dividends without selling, and let compounding do the work.

Interaction with cost basis methods

The capital gain you owe depends on which cost basis method you use when you sell. If you bought the same stock at different prices on different dates, you can choose which “lot” to sell—specific identification, FIFO, LIFO, or average cost. Different choices lead to different gains and different tax bills. Some brokers default to FIFO; you can instruct them otherwise.

Losses and harvesting

Capital losses offset capital gains dollar-for-dollar. If you have $50,000 in gains and $30,000 in losses in the same year, your net capital gain is $20,000. Losses in excess of gains can offset up to $3,000 of ordinary income in a single year, with the remainder “carried forward” to future years until used up.

This creates an opportunity: wash-sale harvesting—selling a losing position to realise the loss (for tax benefit) while repurchasing the same or substantially identical security to maintain your exposure. Tax law limits this: you cannot harvest the loss if you repurchase within 30 days before or after the sale.

See also