Capital Gain

Understanding capital gains thoroughly requires understanding not only the basic definition but also the calculation of basis, the distinction between short-term and long-term gains, the applicable tax rates, the rules governing specific types of transactions, and the planning strategies available to investors seeking to manage their capital gain tax liability.

The Concept of Basis

Basis is the foundation of capital gain calculation and understanding it precisely is essential for accurate tax reporting and effective tax planning. The basis of an asset determines how much of the proceeds from its eventual sale will be treated as a return of the investor's original investment, which is tax-free, and how much will be treated as a gain, which is taxable.

The starting point for basis is the cost basis, which for most purchased assets is simply the purchase price paid for the asset including any commissions, fees, or other transaction costs paid at the time of acquisition. An investor who purchases one hundred shares of stock at fifty dollars per share and pays a ten-dollar commission has a total cost basis of five thousand and ten dollars, or fifty dollars and ten cents per share.

Basis is adjusted over time by various events that change the investor's economic investment in the asset. For stocks and mutual funds, reinvested dividends increase the basis because the investor has paid tax on those dividends as ordinary income when received, meaning they represent an additional economic investment that should not be taxed again when the shares are sold. For bonds purchased at a premium, the premium is amortised and reduces the basis over the life of the bond. For bonds purchased at a discount, the discount may be accreted and increases the basis. For real estate, the cost of capital improvements adds to the basis while depreciation deductions reduce it.

When an asset is received as a gift, the recipient's basis depends on whether the asset is ultimately sold at a gain or a loss. If sold at a gain, the recipient takes the donor's basis, meaning the gain accumulated during the donor's ownership is not eliminated by the gift but carries over to the recipient. If sold at a loss and the fair market value at the time of the gift was below the donor's basis, the recipient's basis for loss purposes is the lower fair market value at the date of the gift, preventing the double counting of a loss.

When an asset is inherited, the recipient receives a stepped-up basis equal to the fair market value of the asset at the date of the decedent's death. This step-up eliminates any capital gain that accumulated during the decedent's lifetime, representing one of the most significant tax planning opportunities in estate planning. An investor who purchased stock for ten dollars per share that has appreciated to one hundred dollars per share has an unrealised gain of ninety dollars per share. If that investor holds the stock until death, the heir receives it with a basis of one hundred dollars per share, and the ninety-dollar per share gain accumulated during the decedent's lifetime is permanently excluded from income taxation.

Short-Term vs Long-Term Capital Gains

The distinction between short-term and long-term capital gains is the single most important distinction in capital gains taxation, determining whether preferential tax rates apply to a gain or whether the gain is taxed at the same rates as ordinary income.

A short-term capital gain arises when a capital asset is sold after a holding period of one year or less, measured from the day after the date of acquisition to and including the date of sale. Short-term capital gains are taxed at ordinary income tax rates, which range from ten percent to thirty-seven percent depending on the taxpayer's total taxable income and filing status. Because short-term gains receive no preferential treatment, they are among the least tax-efficient forms of investment income.

A long-term capital gain arises when a capital asset is sold after a holding period of more than one year. Long-term capital gains are taxed at preferential rates that are significantly lower than ordinary income rates for most taxpayers. The long-term capital gain tax rates are zero percent for taxpayers in the lower income brackets, fifteen percent for most middle and upper-middle income taxpayers, and twenty percent for the highest income taxpayers. These preferential rates apply to long-term gains on most capital assets including stocks, bonds, and real estate, though special rules apply to certain categories of assets as discussed below.

The one-year holding period requirement creates a powerful tax planning incentive to hold appreciated assets for more than one year before selling, converting what would otherwise be short-term gains taxed at ordinary income rates into long-term gains taxed at preferential rates. An investor in the thirty-seven percent ordinary income bracket who realises a gain of one hundred thousand dollars saves twenty-two thousand dollars in federal income tax by holding the asset for just over one year rather than selling a day early, paying at the twenty percent long-term rate rather than the thirty-seven percent short-term rate.

Net Investment Income Tax

In addition to the regular capital gains tax rates, high-income taxpayers are subject to the net investment income tax, enacted as part of the Affordable Care Act and effective beginning in 2013. The net investment income tax imposes an additional three point eight percent tax on the lesser of net investment income or the amount by which modified adjusted gross income exceeds a threshold of two hundred thousand dollars for single filers and two hundred and fifty thousand dollars for married filing jointly.

Net investment income includes capital gains, dividends, interest, rental income, and other passive income. For high-income investors the net investment income tax effectively adds three point eight percent to the tax rate on long-term capital gains, increasing the maximum federal rate from twenty percent to twenty-three point eight percent. Combined with applicable state income taxes, which treat capital gains as ordinary income in most states, the total effective rate on long-term capital gains for high-income investors in high-tax states can approach or exceed thirty percent.

Special Capital Gain Rates for Specific Asset Types

While the standard long-term capital gain rates of zero, fifteen, and twenty percent apply to most capital assets, certain categories of assets are subject to different rates that must be understood for complete capital gains tax planning.

Collectibles including art, antiques, coins, stamps, wine, and similar items are subject to a maximum long-term capital gain rate of twenty-eight percent rather than the standard twenty percent maximum. This higher rate reflects a policy decision to treat gains on collectibles less favourably than gains on productive capital assets such as stocks and real estate.

Section 1250 recapture applies to gains on the sale of real property to the extent that depreciation deductions were taken on the property during the ownership period. The portion of the gain attributable to prior depreciation deductions is subject to a maximum rate of twenty-five percent rather than the standard twenty percent maximum. This recapture provision prevents taxpayers from permanently avoiding taxation on depreciation deductions by converting the ordinary income benefit of those deductions into a capital gain taxed at a lower rate.

Qualified small business stock, defined under Section 1202 of the Internal Revenue Code as stock in certain domestic corporations meeting specified criteria, may qualify for an exclusion of fifty to one hundred percent of the gain on sale, depending on when the stock was acquired and whether the corporation meets the requirements of the provision throughout the holding period. This exclusion is designed to encourage investment in small businesses by reducing or eliminating the capital gain tax on successful investments.

Realised vs Unrealised Gains

A fundamental distinction in capital gains taxation is the difference between realised and unrealised gains, which determines when and whether a gain is subject to tax.

An unrealised gain, also called a paper gain, exists when the current market value of an asset exceeds the investor's basis but the asset has not yet been sold. Unrealised gains are not subject to federal income tax under the current US tax system, which taxes gains only upon realisation through a sale or other taxable disposition of the asset. An investor who purchased stock at ten dollars per share that has appreciated to one hundred dollars per share has an unrealised gain of ninety dollars per share but owes no tax on that gain until the stock is sold.

The ability to defer taxation of gains until realisation is a significant advantage of equity investing compared to investment vehicles that generate current taxable income. An investor who holds a low-basis appreciated stock position for many years allows the full pre-tax value of the gain to continue compounding, deferring the tax liability until the stock is sold and potentially reducing it further through holding period management, charitable giving strategies, or the step-up in basis available at death.

A realised gain occurs when an asset is sold or otherwise disposed of in a taxable transaction. Once a gain is realised, the taxpayer must report it on their tax return and pay any applicable tax in the year of realisation. The tax becomes due regardless of whether the proceeds are reinvested, spent, or held as cash.

Capital Gain Distributions from Mutual Funds

Investors in mutual funds are subject to capital gains taxation not only when they sell their fund shares but also when the fund itself realises gains from selling securities within the portfolio and distributes those gains to shareholders. These capital gain distributions are taxable to shareholders in the year they are received, regardless of whether the shareholder reinvests the distribution in additional fund shares or receives it in cash.

Capital gain distributions from mutual funds are classified as short-term or long-term based on how long the fund held the underlying securities that generated the gain. Long-term capital gain distributions are taxed at the preferential long-term capital gain rates. Short-term capital gain distributions are taxed as ordinary income.

The potential for taxable capital gain distributions is one of the most important tax disadvantages of actively managed mutual funds held in taxable accounts. Active fund managers who trade frequently generate both short-term and long-term capital gains that are distributed to all shareholders, creating a tax liability that reduces after-tax returns. Index funds and exchange-traded funds typically generate far fewer capital gain distributions because their low-turnover strategies rarely require the realisation of gains within the portfolio, making them significantly more tax-efficient vehicles for taxable account investing.

The Wash Sale Rule

The wash sale rule is an important limitation on the ability of investors to realise capital losses for tax purposes while maintaining substantially the same economic position in the investment. Under the wash sale rule, a taxpayer who sells a security at a loss and purchases a substantially identical security within thirty days before or after the sale cannot deduct the loss for tax purposes. The disallowed loss is instead added to the basis of the newly purchased securities, preserving the economic benefit of the loss deduction for the future when the new position is eventually sold.

The wash sale rule applies symmetrically to purchases and sales within the sixty-one day window surrounding the loss sale. An investor who purchases additional shares of a stock thirty days before selling other shares of the same stock at a loss has triggered the wash sale rule, disallowing the loss deduction on the shares sold.

The wash sale rule is relevant to capital gain planning because tax-loss harvesting, the deliberate realisation of capital losses to offset capital gains, is one of the most effective tools for managing after-tax investment returns. Investors implementing tax-loss harvesting strategies must be careful to avoid triggering the wash sale rule by inadvertently purchasing substantially identical securities within the prohibited window.

Capital Gain Planning Strategies

The management of capital gains tax liability is one of the most practically important aspects of investment planning for taxable investors, and numerous strategies are available to reduce, defer, or eliminate capital gain taxes.

Holding period management involves deliberately extending the holding period of appreciated assets beyond one year to qualify gains for long-term treatment, converting short-term gains that would be taxed at ordinary income rates into long-term gains taxed at preferential rates. This simple strategy can dramatically reduce the tax cost of realising gains for investors in high ordinary income brackets.

Tax-loss harvesting involves deliberately realising capital losses on positions that have declined in value to offset capital gains elsewhere in the portfolio, reducing the current year tax liability. Capital losses can offset capital gains dollar for dollar without limitation, and net capital losses of up to three thousand dollars per year can be deducted against ordinary income, with any excess losses carried forward to future years.

Charitable giving of appreciated securities allows investors to donate low-basis appreciated stock directly to a qualified charity rather than selling the stock, paying tax on the gain, and donating the after-tax proceeds. By donating the stock directly, the investor avoids the capital gain tax entirely while receiving a charitable deduction for the full fair market value of the donated securities, providing a double tax benefit that makes charitable giving of appreciated securities one of the most tax-efficient strategies available.

Opportunity zone investing, established by the Tax Cuts and Jobs Act of 2017, allows investors to defer capital gains by reinvesting realised gains in qualified opportunity zone funds within one hundred and eighty days. Gains held in qualifying opportunity zone investments for ten years or more may be excluded from income entirely, providing significant deferral and potential exclusion benefits for long-term investors.

Instalment sales allow sellers of certain assets including real estate and business interests to spread the recognition of capital gain over multiple years by receiving the proceeds in instalments rather than in a lump sum, potentially keeping annual income below the threshold for higher tax rates or the net investment income tax in each year.

Section 1231 Gains and Business Property

For business assets including real estate used in a trade or business, equipment, and other depreciable business property, the capital gain rules operate within a specialised framework under Section 1231 of the Internal Revenue Code.

Section 1231 gains on business property held for more than one year are treated as long-term capital gains if the taxpayer's net Section 1231 gains for the year exceed net Section 1231 losses. However Section 1231 losses are treated as ordinary losses, fully deductible against ordinary income without the three thousand dollar annual limitation applicable to capital losses. This asymmetric treatment, allowing ordinary loss treatment for losses but preferential long-term capital gain treatment for gains, is one of the most tax-favourable provisions in the Internal Revenue Code for business property owners.

Examination Relevance and Key Takeaways

Capital gains are among the most heavily tested tax topics on the Series 65 examination, appearing in the context of investment planning, tax-efficient portfolio management, and the evaluation of after-tax returns. Candidates must understand the definition of a capital gain and the calculation of basis, the distinction between short-term and long-term gains and their applicable tax rates, the net investment income tax and its effect on high-income investors, the treatment of capital gain distributions from mutual funds, the wash sale rule and its implications for tax-loss harvesting, and the primary capital gain planning strategies available to investment advisory clients.

The core points to retain are these: a capital gain is the excess of sale proceeds over the adjusted cost basis of a capital asset; short-term gains on assets held one year or less are taxed at ordinary income rates while long-term gains on assets held more than one year are taxed at preferential rates of zero, fifteen, or twenty percent; high-income investors pay an additional three point eight percent net investment income tax on capital gains; unrealised gains are not taxable until the asset is sold creating a powerful deferral opportunity; the wash sale rule disallows a loss deduction when substantially identical securities are purchased within thirty days before or after the sale; tax-loss harvesting, holding period management, and charitable giving of appreciated securities are the primary strategies for managing capital gain tax liability; and the step-up in basis at death eliminates the capital gain tax on appreciation during the decedent's lifetime making estate planning an important dimension of capital gain management.