Capital Gains Tax 101: Basic Rules Investors and Others Need to Know

Capital Gains Tax 101: Basic Rules Investors and Others Need to Know

Orla O'Connor, Principal, Tax   Mon, July 18, 2022

Billionaire business owner Warren Buffett once famously commented that his secretary paid taxes at a higher rate than he did. Although there are surely many factors at play – among them Buffett's intentionally low salary and his large charitable donations – a big part of the story is that Buffett earns a relatively large share of his income from capital gains.

Income in the form of capital gains has historically been taxed at substantially lower rates than ordinary income like wages, tips, unemployment compensation, gambling winnings, and the like. That's because capital investments are generally viewed by policymakers as engines of growth that stimulate the economy.

The lower tax rates are designed to encourage this beneficial activity. And it's not just the buying and selling of stocks and bonds that receive favorable capital gain treatment. The lower capital gains tax rates apply to profits from other types of investments as well, like the capital gain from the sale of real estate (including your home) or even a small business.

Since the capital gains tax applies to so many types of investment transactions, it's an important piece of the overall tax picture for millions of Americans. But most people don't know much about the capital gains tax – or certainly don't know enough to make informed investment decisions based on the tax consequences of their actions.

The following guide will help you understand the basic rules for the federal capital gains tax. It covers a variety of topics, including what are capital gains, when they're taxed, how to calculate your gain, and what tax rates apply. It also identifies IRS reporting requirements and provides tips for taking advantage of the preferential rates. It's not a substitute for sound professional advice, but it will help investors of all sorts understand the general capital gains tax framework and identify areas where professional help is needed.

What are Capital Gains?

Capital gains are the profit you make from selling or trading a "capital asset." With certain exceptions, a capital asset is generally any property you hold, including:

Investment property, such as stocks, bonds, cryptocurrency, real estate, and collectibles; and

Property held for personal use, such as a car, house, or home furnishings.

There are, however, various special rules that may affect your property's classification or treatment as a capital asset. For instance, if you sell frequently to customers, your property might not be treated as a capital asset. Instead, it may be considered business inventory – and profits from the sale of inventory aren't taxed as capital gains. So, watch out if you sell too many Gucci handbags or real estate investment properties, as these may be treated as inventory, and the tax on any gains will be at the higher ordinary income tax rates.

Similarly, if you sell or exchange depreciable property to a related person, your gains will be taxed as ordinary income.

In addition, intellectual property (e.g., a patent; invention; model or design; secret formula or process; copyright; literary, musical, or artistic composition; letter or memorandum, etc.) is not considered a capital asset if it's held by the person who created it or, in the case of a letter, memorandum or similar property, the person for whom it was prepared or produced.

Plus, although real or depreciable property used in a trade or business is not a capital asset, gains from the sale or involuntary conversion of them may nonetheless be treated as capital gains if they were held for more than one year. So, for all practical purposes, this type of business property is treated as if it was a capital asset.

When are Capital Gains Taxed?

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