What It Is:
How It Works/Example:
The formula for capital gain is:
Sale Price - Purchase Price = Capital Gain
Let's assume you purchase 100 shares of XYZ Company for $1 per share. After three months, the share price increases to $5. This means the value of the has increased from $100 to $500, for a capital gain of $400.
Why It Matters:
Capital gains are taxable, but only when they are realized. That is, they only become taxable when the asset is sold. Until that point, any gains are considered unrealized and are not taxable. The IRS considers nearly every asset owned by individuals and companies as capital assets and thus they are subject to capital gains .
Taxpayers report capital gains on IRS Schedule D, but these gains are subject to different tax rates depending on whether they are short term or long term (and in some cases depending on the type of asset). In the example above, if you sold the XYZ Company after a year, the IRS would consider your $400 a long-term capital gain and would tax it at one of several lower, flat rates. However, if you sold the XYZ Company after just three months, the IRS would consider your $400 a short-term capital gain and tax that $400 at your ordinary income tax rate, which is generally higher than the long-term capital gains tax rate. This system encourages long-term , but there are many reasons an investor might want to sell an asset before a year has passed.
Some retirement vehicles, such as 401(k)s and IRAs, allow investors to buy and sell assets within these vehicles without becoming subject to capital gains tax. This tax deferral effectively gives investors a larger balance on which to compound interest or returns, with capital gains tax applying only when the investor begins to make withdrawals.
An investor's capital losses sometimes offset all or a portion of his or her capital gains, lowering the investor's tax bill. There is a limit, however, to how much the investor can offset. also that the IRS does not treat the distributions of net realized long-term capital gains, like those from a mutual fund, as capital gains. The IRS treats those as ordinary dividends.