Investing provides advantages like dollar cost averaging and compound interest that is essential to the growth of real wealth. When we invest in something whether it be a house, an art collection, or shares of stock we do so with the anticipation that the asset we bought will rise in value. This increase in value has a name, a capital gain.
This article will define what a capital gain is when a capital gain is realized, the two kinds of capital gains, the benefit of a 401(k) or IRA when it comes to capital gains and the reasons why many financial professionals continue to push for no tax on capital gains.
What is a capital gain?
A capital gain is an increase in value between the price an asset (such as real estate or stocks) is sold for and the price that an investor paid for the asset. If a home is purchased for $250,000 and sold for $315,000, the capital gain on that home is a $65,000 (excluding fees and commissions). The calculation is simply:
Sale price – Purchase price = capital gain or in our example 315,000 – 250,000 = 65,000.
In another example, an investor buys 100 shares of Company ABC for $45 per share. His investment is $4,500. At the end of the year, the stock is worth $52 per share. His investment now has a capital gain of $700.
However, only one of these scenarios will cause the investor to pay taxes. To understand which one means understanding when a capital gain is realized.
When is a capital gain realized?
In the case of a home, as well as many other investments, it may take a long time for the asset to rise to a value where we choose to sell it – if we choose to sell it at all. In the case where an asset has increased in value, but an investor has no intention of selling it is there really a capital gain? It’s kind of like asking the question if a tree falls in the forest and nobody hears it, did it really fall? If a capital gain is not yet realized, is it still a gain? The answer is yes, but it is an unrealized capital gain. A capital gain only becomes realized when the asset is sold. The significance of this lies in its tax status.
So in our example above both scenarios triggered a capital gain, but only the homeowner who sold the house would have to pay taxes on the gain. The investor who saw the values of his shares rise would not have to pay taxes on the gain, nor would they even have to report it. They would simply hold on to the shares. The one distinction to this would be if the investor received a dividend from the stock. This dividend, unless it was reinvested into the stock, would be considered taxable income.
How else does timing play into our understanding of capital gains? If the homeowner in our earlier example knows that their home has significant value beyond what they paid for it, they may become interested in selling. For a young couple, they may desire to find a larger home where a couple in, or nearing, retirement, may be looking to downsize. In both cases, one of the considerations that may factor into their decision to sell or not to sell is their realized capital gains.
Once they sell their home a taxable event has taken place. This means that if they sell the home in November, they will have to report the capital gain (in this case $65,000) on their tax return for that year. If they wait to sell until Spring of the following year, they will not have to report it for taxes until the following year. Of course, there are many other factors to consider, but the capital gains should not be overlooked, particularly if the home has seen a significant increase in value.
What are the different kinds of capital gains?
The two types of capital gains are short-term and long-term. Short-term capital gains are defined as gains that occur when an asset is purchased and sold within one year (this is twelve months, not necessarily a calendar year). Long-term capital gains are defined as assets that are purchased and held onto for over a year before they are sold. You might be wondering why is there a distinction? The answer comes down to taxes.
In the case of short-term capital gains, they are taxed as regular income. In fact, the short-term capital gain can actually move individuals or couples into higher tax brackets. Long-term capital gains are taxed at a much lower rate that is determined by an individual’s tax bracket. And because tax rates are first applied to ordinary income, long-term capital gains will not push your income into a higher tax bracket.
Capital gains and your 401(k) or IRA
One of the many advantages of making regular contributions to an employer-sponsored 401(k) or IRA is that the vast majority allow investors to buy and sell securities within the plan without having the profits subject to capital gains. This gives investors a chance to rebalance their portfolio and practice proper asset allocation and diversification without being subject to a taxable event.
What if your investments lose value?
It’s one thing to talk about a capital gain, but what happens when there is capital depreciation? In the case of a home or a collection of items, a drop in value below what an individual paid for it may just be something to be waited out. The real estate market notoriously goes up and down, so unless there is an urgent need to sell, homeowners can generally just hold on to the house until the market conditions become more favorable. The same can be true of collectibles. When the economy is in a recession, the market for these items tends to go down. Once again, unless there is an urgent need to sell, the best course of action may be to simply hold on to the asset.
But what if you’ve invested in a security that has dropped below your purchase price and you are trying to sell to avoid further losses. This would mean you had a capital loss and the good news is you can report this on your taxes, up to a certain amount. In some cases, the losses can offset other capital gains and reduce your tax obligation.
What are forced capital gains?
Unfortunately, there are exceptions to every rule. And one exception to the rules governing capital gains taxation is forced capital gains. There is a somewhat rare event that can happen when the market goes through a period of heavy merger and acquisitions (M&A). When a company is merged with another company, this acquisition can create a taxable event known as a “tax bomb”. This means that if a shareholder holds shares in the old company, they can get taxed on the growth in value that comes when they inherit the appreciated shares of the new company. This can happen even if their intention is to hold the shares and not sell them. An event like this can be particularly difficult for retirees who have accumulated shares over a long period of time at the lower price. 2017 was one of the most active years for mergers and acquisitions in the United States and several forced capital gains events occurred.
One strategy that investors can use to get around this is to gift the appreciated shares to a charity before the shareholder vote of approval on the acquisition.
Should capital gains be taxed?
Death and taxes are the two certainties of life. But there are few topics that get the hackles of investors up more than the idea of being taxed on capital gains. Those that advocate for keeping capital gains taxes as low as possible cite some or all of these reasons.
- In many cases, a capital gain reflects inflation, not a real return rate. After all, a dollar doesn't buy as much today as it did 10 years ago. So an investor who buys a stock for $15/share today and sells it many years from now at $20 per share may see much of his capital gain be taken up by inflation.
- Because capital gains are only realized when the asset is sold, many investors may be “locked in” to an asset and avoid selling it to avoid triggering a taxable event. This can affect an investor’s ability to properly diversify assets.
- You are essentially taxed twice. For individuals who buy shares with after-tax dollars, the capital gains tax is taxing the same income twice. This is because the value of a company’s shares reflects the anticipated future value. That’s why securities are speculative in nature. When share prices rise, there is a capital gain which will be taxed when it is realized – meaning they will have been taxed twice. In the same way, dividends are also taxed twice.
- Our global economy makes capital very mobile. In short, this promotes competitiveness between countries because capital will flee to countries that have favorable tax rates on capital. This can be seen as a threat to job creation in countries that have higher tax rates on capital gains.
The bottom line on capital gains
There was a time when capital gains were considered to be the domain of only the most privileged or “the elite” in our society. But as investing has become more mainstream, individuals of modest means are having to become familiar with capital gains and how they can affect their portfolio.
A capital gain reflects the difference in value between an asset once it is sold compared to the price it was purchased for. If an investor buys 100 shares of stock that are selling at $50 per share and sells it when the stock reaches $55 per share, they will have made a $500 capital gain on the transaction. However, the capital gain is only realized if the asset is sold. In this case, the investor will have to pay taxes on that gain. If they simply choose to hold onto the shares, the capital gain still exists but is considered unrealized. If the stock would drop below $50 in value before the investor sells, they would take a capital loss on that asset.
When an asset is sold is also important to understanding capital gains. There are short-term and long-term capital gains. Short-term gains are defined as gains that happen when an asset is held for less than one year. Long-term gains are those when an asset is held for longer than a year. Short-term capital gains are taxed as regular income whereas long-term capital gains are taxed at a much lower rate.
One way for buy-and-hold investors to get around capital gains is to own shares through an employer-sponsored 401(k) or IRA. This allows them to buy and sell shares within the funds without triggering a capital gains event. This can be critical for proper diversification and asset allocation strategies.
The opposite of a capital gain is a capital loss. This takes place when an asset is sold for less than the price it was purchased for. In some cases, capital losses can be taken strategically to offset capital gains and help reduce tax liability.
Capital gains will remain a source of debate not only in our country but in other developed nations. The issues of inflation, double taxation, and the flexibility of investors to diversify into other assets as well as concerns about keeping a nation's economy competitive in a global market continue to be debated.