A brief overview of tax rules that apply to capital gains and losses.
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The tax law divides income into two broad categories: ordinary income and capital gains. Ordinary income includes wages, of course, but also includes some types of investment income, such as interest you receive. You have capital gain when you sell an investment at a profit, or when capital gain passes through to you from a mutual fund or other entity. Capital gains can receive favorable tax treatment, while rules that apply to capital losses may limit your ability to use them.
Favorable rules for capital gains
Tax rules generally favor capital gain over ordinary income.
Lower rates. Profit from selling an investment you’ve owned more than a year is long-term capital gain that qualifies for lower tax rates. As of 2018 we have three rates for long-term capital gain:
- At lower income levels, the rate for long-term capital gain is 0%.
- In the middle range, the rate for long-term gain is 15%.
- The rate for higher-income taxpayers is 20%.
Visit our Reference Room for tax bracket figures.
Avoiding capital gain tax. In addition to the 0% rate mentioned above, you can avoid paying tax on capital gain in other ways:
- A generous exclusion ($250,000 for singles, $500,000 for couples) applies to gain from the sale of your principal residence.
- Gain on investments donated to charity may escape taxation.
- Profit built into investments held at death won’t be taxed to you, or to your estate or your heirs.
Flexible timing. Often you can get a better tax result by choosing when to sell your investments:
- Postpone profitable sales until they qualify for the lower rates that apply to long-term capital gains.
- Postpone them further to defer tax on the gain until a later year.
- Choose the most favorable time to “harvest” capital losses by selling investments that have lost value.
Measuring capital gain
Your capital gain from a sale is measured by the difference between the amount realized in the sale and your basis in the asset you sold. Roughly speaking, the amount realized is what you received on the sale — usually measured by the sale price minus costs of sale such as a brokerage commission. Your basis is based on your cost but may be adjusted as a result of various events such as stock splits.
Example: You buy 100 shares of XYZ at $35, paying $3,500 plus a brokerage commission of $20. Your basis is $3,520. Later, you sell when the stock is at $39. You receive $3,900 minus a brokerage commission of $20, so your amount realized is $3,880. Your capital gain is the difference between $3,880 and $3,520, or $360.
If your basis is greater than the amount realized, you have a capital loss.
Rules for capital losses
We have many special rules for capital losses. Here are the most important ones:
- Overall limitation. You can deduct capital loss up to the total amount of capital gain plus $3,000. Capital loss that remains unused because of this limitation carries over to the next year (and if still unused, to subsequent years, without limit).
- Matching. If you have gains and losses in both categories (short-term and long-term), you have to match losses and gains in the same category. This means a short-term loss (which counts first against short-term capital gain) can be more valuable than a long-term loss (which counts first against long-term gain).
- Wash sale rule. You aren’t allowed to claim a capital loss on sale of an investment if you buy a substantially identical investment (usually shares of the same stock or mutual fund) within 30 days before or after the sale.
- Personal use property. You can’t claim a capital loss from selling property you used, such as your home.
Overall, the rules for capital gains and losses are favorable, but careful planning may be required to get the best results.