What Are Capital Gains?

In the world of investing, finance, and taxes, the words "capital gains" have a specific meaning. What are capital gains? Capital gains are profits made from investing your capital, or excess money. You can invest in gold coins, real estate, stocks and bonds, cars, race horses, all kinds of things. When you invest, you pay a certain purchase price for something. When you sell it, you get a certain price for it. If you sell it (the stock, the gold, the real estate) for more than you paid for it, you have a capital gain. If you sell it for less, you have a capital loss. Normally, this wouldn't matter to anyone but you, as you fine tune your investing criteria to make more gains and less losses. But unfortunately, we live in a world of big government that believes it has a right to a share of any gains you make via taxation. Pour through annual reports, study hundreds of businesses, save all your money (after you have already paid taxes on it once) and invest it in some stock. You do all this work, pick the right stock, it goes up, you sell it -- and now the government tells you to give them 15-35% of your profits as THEIR share. Hey, turns out you have a silent partner that earned none of the money, took none of the risks, did none of the investing analysis, yet still claims ownership to yoru profits. That is called the capital gains tax, rightly argued as one of the most unfair taxes in existence. In this guide, we will take a look at capital gains taxes, what the tax rates and tax tables are, how gains are calculated, long term vs. short term capital gains, and how you can minimize your capital gains tax.

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Why are capital gains taxed?

Before we go too far, take a minute to think about the issues involved here. You have a job. You work. You earn $100 this year. You pay $6 in FICA social security taxes, $3 in Medicare taxes, then $20 to the Federal government (IRS), and $7 to your state government. Another $3 for local property tax, $2 for sales tax, and you end up with $59 that the government actually lets you keep out of your $100 that you earned. Now you pay for your mortgage, your food, clothing, cars, insurance, utilities, vacation, entertainment, and you end up being able to save $4 this year. You work all year to earn $100 and you actually save $4 of that, not too mention that you already paid 10 times that, $41 in taxes. So you take your paltry $4 year after year, and you think about investing it. You invest in some stocks, you buy an apartment building with your brothers, and over the years your investments increase. So your earnings have already been HEAVILY taxes, you struggle and manage to save just a tiny % of all your earnings and invest it for your future, and now the government comes along AGAIN and says they want to tax you on your investments, AGAIN! How many time can you or should you be taxed on the same money? You started with $100, paid $40 in taxes, kept just $4 and invested it and turned it into $10, now the government wants $2 of that little $6 gain? Are they crazy? Are we crazy? First they took 10X what we were able to keep and save, now they want more out of what we have worked to turn our savings into? If that sounds preposterous to you, welcome to the reason than Republicans have worked to reduce capital gains taxes. Unfortunately, we live in a biased world, where a lot of wealthy people make money by investing, and we think it is right to tax and punish these successful people. Now it is true that some people inherit their wealth and do nothing to earn in, but most people start out small just like our hypothetical $4 investor and slowly turn it into something over years and decades of investing. Do we really want to keep taxing these people? How can it be justified?

Unfortunately, no one speaks for these people - they are a small minority, and in a democracy, the majority rules and can choose to tax these people into poverty if they like. If you struggle and save and invest successfully and allow your benefits to help your children buy a home or go to college, do you think it is fair to be taxed again on your investments, just because your kids didn't earn the money? At some point, we just have to say, no more taxes. We've been taxed and taxed and taxed again, stop. Think about it next time you vote for someone - where do they stand on taxes and capital gains taxes? Make your vote count.

Long Term Capital Gains vs. Short Term Capital Gains

What are short term capital gains? Further complicating the picture is the distinction between short term and long term capital gains. When you think about it, does it really matter if you made money investing in a stock or property for 360 days or 3 years? The amount of time required for you to make a gain seems meaningless, and it is. But the government has decided that if you are smart enough to make a gain in less than the time it takes the Earth to go around the Sun (1 year), that is a speculative, gambling-style gain and it should be taxed at the maximum level -- this is called a short term gain. If it takes one day over a year or 2 years or 10 years, then it is called a long term capital gain, and is taxed at much more favorable levels. How are capital gains taxes calculated? Short term capital gains are taxed at your ordinary income tax rate, which depends on your total income. For 2006, ordinary income is taxed at the following rates for a married couple filing separately:

• $0-$7550 = 10%
• $7550 - $30650 = 15%
• $30650 - $61850 = 25%
• $61850 - $94225 = 28%
• $94225 - $168275 = 33%
• $168275 - infinity = 35%

That's the federal tax table. Consider this. If you make $500K and someone else makes $5K, not only do you pay 100X more in taxes than they do (since you make 100x more), thanks to this progressive tax schedule, you actually get to pay more like 350 times more - quite a deal.. So whatever your marginal tax rate is, your short term capital gains are taxed at that rate. For example, if you made $90,000 on this table and had $10K in short term capital gains, the first $4225 would be taxed at 28% and the remaining portion, which pushes you into the next bracket, would be taxed at 33%. So short term gains are treated exactly the same as getting an extra paycheck from work, if that helps you to understand it. Long term capital gains are generally taxed at just 15%, as are dividends. Long term gains apply to gains on investments held for longer than 1 year. However, if you are in a lower tax bracket, namely the 10% or 15% rates, you instead pay 0% or 5% on your long term capital gains. Another exception is for your home. If you use a house as your main residence for 2 years of the 5 years before selling it, you get an exemption on the first $250K of capital gains, $500K for married couples, for which no tax is due. Gains in excess of these amounts are taxed at the long term rate of just 15%. This is a far cry from the situation 10 years ago (1997 - there used to be an exemption for older home owners and you could avoid the tax temporarily by rolling over the proceeds into a more expensive home) when gains made on the sale of a home were fully taxable. Imagine buying a house for $100K, ten years later with inflation it is worth $200K and all the house on the street sell for $200K. You sell yours, the IRS makes your recognize a capital gain of $100K and pay $30K of that in taxes, leaving you with $170K - you can't even buy the same house back with that. Of course if you lost money on a home, the IRS allowed you to eat all those losses and not deduct them -- they only shared in everyone's gains, not in the losses. Fortunately this law was changed so that people can now keep most of the profits from the gain of the sale of their home (which aren't really gains, just appreciation that all homes have experienced). If you have a second rental property, you can sell the first, pocket the gain, then move into the second for 2 years and sell it and keep the gains on it as well.

Real estate owned as an investment is generally taxed at 25%, and collectibles (coins, baseball cards, etc.) are generally taxed at a maximum of 28%. You can refer to IRS.gov for additional information and requirements for calculating capital gains tax owed.

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