What is a Capital Gain?
A Capital Gain occurs when the value of an investment – typically in equity (stocks) or debt instruments – rises above the initial purchase price post-sale.
- What is the definition of a capital gain?
- How are capital gains taxed in the US?
- What is the difference between unrealized and realized gains?
- How do short-term and long-term holding periods impact taxes?
Capital Gain Definition
If an investment is sold at a price that exceeds the original price paid on the date of initial investment, then there is a capital gain.
The most common examples of assets that are regularly purchased and sold are:
- Debt (Bonds, Loans)
- Real Estate
Conversely, if the investment is sold to a buyer at a price lower than the initial price, there is no capital gain, but rather a capital loss – which brings about certain implications to taxes.
Capital gains can be taxed, unlike capital losses, which cannot be taxed.
Moreover, capital gains are factored into a specific individual/company’s taxable income (EBT) and are charged at the prevailing tax rates in the appropriate jurisdiction.
Topic No. 409 Capital Gains and Losses (Source: IRS)
Unrealized vs Realized Capital Gains
If an investment is sold, meaning that there is now a new owner of the investment, the capital gain is considered to be “realized.”
Further, if you realize a capital gain post-sale, the proceeds are deemed taxable income.
By contrast, if the value of an investment is higher than entry but the holders of the asset have not yet sold it, the capital gain is “unrealized.”
Realized capital gains occur on the date of exit, as this triggers a taxable event, whereas unrealized capital gains are simply “paper” gains/losses.
Why is this important?
An investor is NOT taxed until the investment is exited and a profit is obtained.
Unrealized gains, also referred to as “paper gains,” are NOT taxable.
Short-Term vs Long-Term Capital Gain
Furthermore, capital gains can be categorized as either:
- Short-Term: Holding Period <1 Year (or)
- Long-Term: Holding Period >1 Year
The importance of the distinction is tied to taxes, as income taxes are directly impacted by the duration of the holding period.
In particular, investors with short holding periods – e.g. day-traders – must take into consideration the higher tax rate for near-term trading.
Long-term capital gains, compared to short-term capital gains, are taxed at a lower rate.
- Short-Term Tax Rate: Matches the Ordinary Income Tax Rate Brackets – 10% to 30%+
- Long-Term Tax Rate: Taxed Lower than Ordinary Income – 15% to 20% (or 0% if No Taxable Income)
The rationale for long-term capital gains to be taxed lower is to reduce the volatility in the market and provide an incentive for longer holding periods (i.e. promote market stability).
Hence, value investors purchase securities with the intent to hold onto the investment for a long duration before exiting.
Capital Gain Tax Calculation Example
To reiterate from earlier, a capital gain is triggered when you sell an investment for a net profit.
For our example scenario, let’s assume that a company based in the U.S. has $10 million in taxable income for the year.
In addition, the company has exited an investment with a total capital gain of $2 million – which is taxed at 21% (i.e. the corporate tax rate).
- Tax Liability = ($10 million + $2 million) * 21%
- Tax Liability = $2.5 million
Given a tax rate of 21%, the tax liability is equal to $2.5 million, inclusive of the capital gains tax of $420k.