Capital Gain

Capital gain refers to the profit resulting from selling a capital asset or investment at a price higher than its purchase price. The concept applies to almost anything of value, including real estate, investment property, stock, mutual fund, or bond.

It is the opposite of capital loss, where the selling price of an asset or investment is less than its purchase price. A short-term or long-term gain may occur depending on the asset holding period and is liable to income taxes. However, the government offers tax exemptions to those reinvesting their capital profits within a specified period.

• Capital gain simply means the profit made by an individual after selling a capital asset or investment at an increased price compared to its purchase price. Real estate, investment property, stocks, mutual funds, and bonds are just a few examples.  
• An individual who attains the profit on selling the asset is applicable for the capital gain tax imposed by the Internal Revenue System (IRS) based on its type.
• A short-term gain is a profit earned from selling an asset held for a year or less. The profit earned on an investment held for more than a year is the long-term gain.
• The short term capital gains tax is comparatively higher than that for a long-term profit.

Individuals can earn a profit on their assets in two ways. First, when the price of an investment appreciates while they hold it, as it reflects an increase in its value. Second, when they realize an increase in the value of a capital asset or investment during its final sale. In simple words, a capital profit of gain is a difference between the prices (usually higher) at which someone sells and purchases the investment.

A typical example of this is Albert buying a mini-rolling machine for $450 for his workshop. After six years, he sold it for $600 and made a gain of $150.

The financial gain generates an income for the seller and is subject to income tax, referred to as a capital gain tax. The U.S. Internal Revenue System (IRS) imposes a tax on the seller on making a profit. In case of a capital loss, the IRS allows the seller to deduct a particular amount, thereby reducing their taxable income for the year.

Understanding capital profit and tax is essential for an individual to make better decisions when selling an asset or investment.

Depending on whether the asset's value increased during the sale or when it was unsold, the gain can be realized or unrealized.

In other words, the profit earned from the asset's sale is the realized gain. The unrealized gain is the difference between the asset's acquisition price and its current price when it is unsold.

For example, if someone buys $500 worth of shares and sells them for $700, they have realized a gain. If the value of the shares appreciates to $1,000 when it was unsold, the price difference is an unrealized gain.

Another thing that distinguishes realized from unrealized gain is the taxation rules that apply exclusively to the former. The IRS tax rate applicable to a capital profit depends on how long someone held an asset or investment and their taxable annual income.

Based on the amount of time an item or investment has been held, realized gains are of two types:

#1 - Short-Term Gain

• It is the profit resulting from the sale of assets or investments held for a year or less. The gain is applicable for regular income taxes up to 37%.
• Selling a company stock when its price exceeds the purchase price is a perfect example of this.

#2 - Long-Term Gain

• It is the gain acquired after the selling of assets or investments held for more than a year. It is subject to a tax rate of 0%, 15%, or 20%, lower than regular income taxes.
• For example, Sandra purchased $14,000 worth of shares in a company in 2010. She sold the shares for $16,500 in 2018, netting a profit of $2,500, which will be subject to a capital gain tax.

In April 2021, United States President Joe Biden proposed to increase the tax rate on long-term capital profits or gains from 20% to 39.6% for taxpayers earning more than $1 million. It means long-term profits will now incur the same tax rate as short-term gains for ordinary income.

The higher tax rate will contribute to the $1.8 trillion stimulus plan American Families Plan, which aims to prolong and improve tax credits for American families.

Let us look at the examples of capital profit on stocks and bonds and from home sales to understand the concept better:

#1 - Capital Gain On Stocks

Jim is a salaried employee at a software company. In 2019, he purchased some shares in Google, Inc. and sold the same at an increased price in 2021. These shares are the capital assets of Jim, who has been holding them for more than a year. Such shares fetch him a long-term gain when sold at a rate higher than their purchase value.

#2 - Capital Gain From Home Sale

Cindy purchased a lake-view house for $400,000 in Davenport, Florida, in February 2013. She sold the property for $500,000 in June 2018. The lakefront house is a capital asset of Cindy, which resulted in a long-term gain of $100,000 upon sale. Also, this gain will get taxed under the long term capital gains tax.

#3 - Capital Gain On Bonds

In the case of corporate bonds, gain occurs when the investor sells bonds before maturity. For example, Mellisa owns a corporate bond and wants to sell it before its maturity. She receives a small profit more than the purchase price, i.e., a short-term gain. This profit will get taxed under the regular income tax rate. Mellisa's earnings will be taxed at the long-term gains rate if she sells her bond after a year but before it matures.

This has been a guide to What is Capital Gain and its Meaning. Here we discuss capital gain understanding and categories, along with their examples. You may also have a look at the following articles to learn more –

• Short Term vs Long Term Capital Gains
• Capital Gains Yield
• Capital Gains Yield