How are capital gains taxed?
Capital gains are profits from the sale of a capital asset, such as shares of stock, a business, a parcel of land, or a work of art. Capital gains are generally included in taxable income, but in most cases are taxed at a lower rate.
A capital gain is realized when a capital asset is sold or exchanged at a price higher than its basis. Basis is an asset’s purchase price, plus commissions and the cost of improvements, minus depreciation. Similarly, a capital loss occurs when an asset is sold for less than its basis. Gains and losses (like other forms of capital income and expense) are all measured in nominal terms—that is, not adjusted for inflation.
Capital gains and losses are classified as long term if the asset was held for more than one year, and short term if held for a year or less. Taxpayers in the 10 and 15 percent tax brackets pay no tax on long-term gains on most assets; taxpayers in the 25-, 28-, 33-, or 35- percent income tax brackets face a 15 percent rate on long-term capital gains. For those in the top 39.6 percent bracket for ordinary income, the rate is 20 percent. Short-term capital gains are taxed at the same rate as ordinary income. There also is a 3.8 percent tax on net investment income for single taxpayers with modified adjusted gross income above $200,000 ($250,000 for married couples filing jointly). Note, too, that capital gains in some cases face an effective tax rates above the 23.8 percent statutory rate because of phaseouts in the tax code.
Gains on art and collectibles are taxed as ordinary income up to a maximum 28 percent rate. Taxpayers may realize up to $250,000 of gains on their principal residences tax free (or up to $500,000 for married taxpayers filing jointly). Individuals may exclude up to 50 percent of capital gains on stock held for more than five years in a domestic C corporation with gross assets under $50 million on the date of the stock’s issuance.
Capital losses may be used to offset capital gains, along with up to $3,000 of other taxable income. The unused portion of a capital loss may be carried over to future years.
The tax basis for an asset received as a gift equals the donor’s basis. However, the basis of an inherited asset is "stepped up" to the value of the asset on the date of the donor’s death. The step-up provision effectively exempts any gains on assets held until death from income tax.
C corporations pay the regular corporation tax rates on the full amount of their capital gains and may use capital losses only to offset capital gains, not other kinds of income.
For most of the history of the income tax, long-term capital gains have been taxed at lower rates than ordinary income. Since 2003, qualified dividends have also been taxed at the lower rates. Figure 1 below shows how the maximum long-term capital gains tax rate and the maximum ordinary individual income tax rate has changed over the years.
Department of the Treasury, Office of Tax Analysis. 2015. ”Taxes Paid on Capital Gains for Returns with Positive Net Capital Gains 1954–2012.” Washington, DC: Department of the Treasury.
Tax Policy Center. 2015. "Historical Highest Marginal Income Tax Rates." Washington, DC.
Auten, Gerald. 2005. “Capital Gains Taxation.” In Encyclopedia of Taxation and Tax Policy, 2nd ed., edited by Joseph Cordes, Robert Ebel, and Jane Gravelle, 46–49. Washington, DC: Urban Institute Press.
Burman, Leonard E. 1999. The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed. Washington, DC: Brookings Institution Press.
Kobes, Deborah, and Leonard E. Burman. 2004. “Preferential Capital Gains Tax Rates.” Tax Notes, January 19.