Capital Gains Tax

A capital gains tax is levied on the profit realized when an asset—stock, real estate, cryptocurrency, commodity—is sold for more than its purchase cost basis. Governments distinguish between long-term gains (held >1 year, taxed at preferential rates, often 0–20%) and short-term gains (held <1 year, taxed as ordinary income, up to 37% federally in the US). The rate asymmetry encourages long-term investing and discourages frequent trading.

How gains are calculated and taxed differently

When you buy a stock for $100 and sell it for $150, the $50 gain is a capital gain. If you held the stock for more than one year, it qualifies for long-term capital gain treatment and is taxed at a lower rate. If you held it for one year or less, it is a short-term capital gain and is taxed as ordinary income—potentially at a much higher marginal rate.

This rate asymmetry is intentional: governments want to encourage investors to hold assets longer, stabilizing markets and generating government revenue from long-term wealth creation rather than short-term trading churn. It also reduces portfolio turnover and associated trading costs, which benefits savers overall.

Long-term capital gains rates and income brackets

In the US, long-term capital gains tax rates are:

• 0% for lower-income filers (roughly <$45k single income in 2024).
• 15% for middle-income filers (most of the tax-paying population).
• 20% for high-income filers (above ~$550k single income).

These rates are much lower than ordinary income rates (up to 37% at the top federal bracket). A high-earning investor in the 37% marginal bracket saves 17 percentage points (37% − 20%) by waiting one year for long-term treatment.

Some states (e.g., California, New York) add additional capital gains taxes, bringing the total rate to 40%+ for top earners, creating strong incentives for residence arbitrage (moving to lower-tax states before realizing large gains).

Wash sale rules and tax-loss harvesting

A wash sale occurs when you sell a security at a loss and buy a substantially identical security within 30 days before or after. The IRS disallows the loss deduction on the grounds that you haven’t truly exited the position. This rule prevents traders from harvesting tax losses repeatedly while maintaining economic exposure.

However, tax-loss harvesting is a legitimate strategy: you sell a losing position to realize the loss for tax purposes, and immediately buy a similar (but not substantially identical) position to maintain exposure. The loss offsets other capital gains or up to $3,000 of ordinary income per year; excess losses carry forward indefinitely.

Pass-through entities and self-employment taxation

Owners of LLCs, S-corporations, or partnerships report capital gains from operations on their personal tax returns at capital gains rates. But they also pay self-employment taxes on ordinary business profits (15.3% combined employer-employee Social Security and Medicare taxes). A savvy business owner tries to characterize as much income as capital gains (eligible for preferential rates) rather than salary (subject to self-employment taxes), but the IRS scrutinizes aggressive interpretations.

Installment sales and deferral mechanics

An installment sale allows a seller to receive payment over multiple years (e.g., owner financing of real estate). The seller recognizes a pro-rata portion of the capital gain each year as payments arrive, spreading the tax bill and potentially reducing marginal tax rates in any single year. For a $100k gain realized over 5 years ($20k annually), you might stay in the 15% bracket all five years rather than spike to the 20% bracket in year one if all $100k were recognized.

This is a form of tax deferral and rate optimization.

Step-up in basis and estate planning

One of the most powerful capital gains incentives is the step-up in basis at death. If you buy an asset for $100 and it appreciates to $1 million, your heirs inherit it at a “stepped-up” cost basis of $1 million (the date-of-death value). If they sell it immediately for $1 million, there is zero capital gain tax. The entire appreciation is forgiven.

This creates a massive incentive to hold appreciated assets until death rather than selling and gifting or donating during life. Wealthy families use this structure aggressively, and periodic attempts to eliminate step-up basis have failed politically because it is so broadly popular.

Cryptocurrency and wash-sale complications

Cryptocurrency transactions trigger capital gains tax upon sale or exchange, even if you swap one coin for another (e.g., Bitcoin to Ethereum). The IRS treats this as a taxable event. The wash-sale rule technically does not apply to crypto (no explicit statutory mention), but the IRS has not clarified, creating uncertainty.

This ambiguity, combined with high volatility and frequent trading, has led to capital gains tax disputes and has motivated crypto-wash-sale-rules proposals.