What is the Capital Gains Tax?

Deductions and Credits, Taxes 101

The IRS deems all taxable income as one of two types: ordinary and capital gain.  Most income is considered ordinary and includes:

  • Salary or hourly wages
  • Interest income
  • Self-employment income (e.g., freelancing or otherwise running your own business)
  • Rental income

Capital gains income result from the selling of certain items for more than you paid for them.  Examples of transactions which often trigger capital gains include:

  • Stocks sales
  • Mutual fund sales
  • Home sales

There are two kinds of capital transactions: short-term and long-term. Short-term transactions occur if the sale happens a year or less after the purchase. Short-term capital gains are taxed as ordinary income. However, long-term capital gains (where the taxpayer owned the asset for more than one year), are taxed at capital gains tax rates.

At most times in our history including today, top ordinary income tax rates exceed top capital gains tax rates. Consequently, you’d prefer income from a capital gains transaction over the same event triggering ordinary income.

Calculating Capital Gains Tax

To determine the extent of a capital gain or loss, you simply subtract your basis in the asset you sold from its sales price. If your basis is less than the sales price, you have a capital gain. If your basis exceeds your sales price, you have a capital loss.  Let’s take an example.

Say you sold 101 shares of the stock HLMA on November 10, 2010 for $15/share.  You used a discount broker, so your commission on the trade was just $7.  The net proceeds from the stock sale are $1,508 ((101 shares x $15 price) – $7 commission).

You originally purchased 100 shares on April 26, 2008 for $12/share also paying a $7 commission.  Your total purchase price is $1,207 ((100 shares x 12 price) + $7 commission).

Since you paid $1,207 for a stock you sold for $1,508, you have a capital gain of $301 ($1,508 – $1,207), right?

While many would calculate their gain that way, it might lead to an overpayment of tax, because your basis is not always exactly equal to your purchase price. Perhaps you noticed our example features a sale of 101 shares but a purchase of only 100. Where did the other share come from? It turns out HLMA paid a $20 dividend on December 13, 2009. At that time, HLMA was trading for $20/share (Yes, last December would have been a better time to sell our fictional stock but, alas, there is no crystal ball). Upon your instructions, your broker took the $20 dividend and bought another share of HLMA, otherwise known as reinvesting your dividend.

When you calculate your basis in the HLMA stock you sold, add the $20 to your basis. Therefore, your total capital gain is actually $281 ($1,508 sales price – $1,227 basis).  Your capital gains tax rate currently varies based on your total income, but the highest current rate is 15%, so the most tax you’d owe on this hypothetical stock sale is $42.50 (15% x $281 capital gain).

Note:  the maximum capital gains tax rate is set to rise to 20% on January 1, 2011. Whether and to what extent tax legislation passes affecting 2011 tax rates is currently anyone’s guess. Hmm, sounds like a future blog posting at the TurboTax blog.