Capital gains tax is a type of tax applied to a profit when selling an asset. It often occurs in sales of stocks and bonds, but is also applied to real estate and other personal investments. Thus, every taxpayer, especially investors, must know and understand some basic terms and ideas if they are to be prepared.
What is a capital gains tax?
A capital gains tax is applied to the profit realized from selling an asset at a much higher price than its purchase price. Capital gains tax does not apply to unrealized gains—it is only imposed once the asset is actually sold. The factors that affect the amount of tax that one pays are income level, marital status, and the principal (base) cost of the investment.
What is capital gain?
Capital gain is the profit one earns from investing in something and then selling it at a higher price. Expressed as an equation, it is:
Selling Price - Cost Base = Capital Gain
What are capital assets?
Capital gains tax is generally applied to capital assets, which includes:
What are long-term and short-term gains?
The tax computation will also depend on how long you have owned a particular asset. If you sell it after owning for more than a year, the gain is a long-term capital gain. If you sell it after owning for a year or less, then it’s a short-term capital gain.
The tax rate from short-term gains is higher than that from long-term gains. Thus, in most cases, a “buy and hold” investment strategy is more appealing. Holding investments for over a year before selling is a great way to increase after-tax returns.
What happens when there is capital loss?
Unfortunately, the value of investments does not always increase. If you sell something at a lower price than the cost base, then one has what is known as a capital loss. Capital losses from investments will offset taxes on capital gains.
For example, if you have a long-term gain of $100,000 from the sale of one stock, but a long-term loss of $50,000 from the sale of another, then you will be taxed for only $50,000 worth of long-term gains.
Understanding tax structure should be a major part of any financial planning strategy. When overlooked, taxes can reduce expected investment returns and can certainly jeopardize long-term goals. While this particular toll disproportionately affects different individuals depending on their assets and investments, nobody can avoid the imposition of taxes, including capital gains. At CS Accounting, we take taxes very seriously. We take pride in simplifying such complicated processes in order to give our clients peace of mind. We encourage you to contact us with questions or concerns on this or any financial subject.