Definition of Capital Gain

A capital gain is the profit realized from holding a security.  A short-term capital gain is the profit realized on a security held for one year or less.  A long-term capital gain is the profit realized on the sale of a security held for more than one year.

How to Calculate Short and Long-Term Capital Gains

The basic rule for calculating capital gains is the sales price minus the cost of selling less the adjusted tax basis (cost basis), which equals the taxable capital gain or loss.

The general principle is that a taxpayer must net short-term capital gains against short-term capital losses to get a total short-term capital gain or loss. Then net long-term capital gains against long-term capital losses to get a total long-term capital gain or loss. Finally, net the total short-term capital gain or loss against the total long-term gain or loss.

If the result is a capital loss, whether short-term or long-term, up to $3,000 of it (or up to $1,500 for married people filing separately) can be deducted from ordinary income. If capital losses exceed this amount, an investor can carry them over and deduct them in subsequent years until they are used up.  Short-term and long-term capital loss carryovers retain their short or long-term character when they are carried over.  This implies that in a subsequent year a long term capital gain cannot be reduced by a capital loss carryover and the taxpayer may end up paying a tax on that gain.

How Capital Gains Tax is Calculated

Short-term capital gains are taxed as ordinary income. Therefore, the nominal tax rate will be whatever tax bracket the investor is in.

The majority of people now only have two capital gains tax rates to worry about - 5 percent and 15 percent. Long-term capital gains are taxed at 5 percent for taxpayers in the 10 or 15 percent income tax bracket overall and 15 percent if taxpayers are in any other tax bracket. The long-term capital gains are included when figuring out the investor's tax bracket. However, the 5 percent or 15 percent rates do not apply to all long-term capital gains. Long-term capital gains on collectibles, some types of restricted stock, and certain other assets are instead subject to a minimum 28 percent rate.

It is important to note that corporate actions change the cost basis of a security.  It cannot be assumed that the purchase price is the cost basis.  It is important to track corporate actions because otherwise investors can significantly overstate capital gains increasing tax costs.  They can also understate capital gains leaving them liable for back taxes, interest and other penalties.

Wash sales  pose another challenge in calculating capital gains tax. A wash sale is trading activity in which shares of a security are sold at a loss and a substantially identical security is purchased within 30 days. The subsequent purchase could occur before or after the security is sold, creating a 61-day window. A wash sale will defer losses (possibly increasing capital gains tax due) and increase the cost basis of the new tax lot.

Generally, the proceeds of any stock, bond, or other securities sold during the year will be reported on IRS Form 1099-B by the brokerage or financial institution that carried out the sale.

Tax Considerations Can Complicate Market Capital Gains and Losses

Long-term Capital Gains:  As of May 6, 2003 (through 2008), the long-term capital gains rate has been reduced to 15 percent for taxpayers in the 25 percent and higher income tax brackets and to 5 percent for those in the 10 and 15 percent income tax brackets. If these capital gains were realized before May 6, 2003, they are subject to the old capital gains rates of 20 percent for those in the 25 percent and above income tax brackets and 10 percent for those in the 10 and 15 percent tax brackets.  The higher the income, the greater the spread is between the ordinary tax bracket and the capital gains tax rate.

For securities sold before May 6, 2003 which were held for more than five years, the tax rate is 8 percent.  The chart below shows tax brackets and the corresponding long-term capital gains tax rate.

Tax Bracket Long-term Capital Gains Rate (%) Pre May 6, 2003 Post May 6, 2003 10% / 15% 10% 5% 15% +   20% 15% 10% / 15% and 5% Property 8%

Example:  An investor in the 33 percent tax bracket trying to decide whether to sell 100 shares in Stock A that she purchased nine months ago or 100 shares of Stock B she purchased two years ago, when both are going to generate a capital gain of $5,000, would find the amount she actually keeps is quite different depending on which she sells. Selling Stock A would result in a short-term capital gain taxed at her 33 percent ordinary income level for a total tax of $1,650.  If she sold Stock B she would have a long-term capital gain taxed at the capital gains rate of just 15 percent for a total tax of $750.  She saves $900 in taxes by selling Stock B.

Harvesting for Losses:  Given the rapid climb and subsequent fall of the stock market over the last few years, many individuals are likely to have a few holdings in their portfolios that are near worthless. From a tax standpoint, selling these holdings can generate losses, which may help offset capital gains to further reduce tax costs.

Example:  An investor who purchased a stock at $100 per share in 1999, which is now trading at just $2 per share, could realize $10,000 in long-term losses. This loss could be written off against up to the same amount in capital gains from other investments sold during the year or up to $3,000 in ordinary income. Any amount that could not be realized as a loss in 2004 can be carried forward to write off against capital gains or ordinary income in future years.

Designating Investment Sell Methodologies:  Another tax advantage strategy is to use the specific ID method to identify the tax lots most advantageous to sell, rather than simply defaulting to the IRS' first in first out (FIFO) method for stocks and average cost for mutual funds, which generally are not the most efficient options for taxpayers.

Example:  Assume an investor is in the 25 percent income tax bracket. In December 2001 he invested $10,000 in shares of QRS Company.  His adjusted cost basis for those shares is $25 per share. In August 2002, he purchased $5,000 more shares now with an adjusted cost basis of $50 per share. In December 2004, with the share price now at $55, he decides to sell 100 shares.  If FIFO is used, it would conclude that he had sold 100 of the first shares he bought. His cost basis was $25 a share and he sold 100 shares for $55 each, realizing a $3,000 capital gain ($55 less $25 times 100).

Because he held the investment for more than one year and is in the 25 percent income tax bracket, his tax on the $3,000 capital gain is $450. However, if he had indicated to sell 100 shares from the tax lot he purchased in August 2002 with a basis of $50 per share, he would only have realized a capital gain of $5 per share for a total capital gain tax of just $75 ($55 less $50 times 100) versus $450.  By using Specific ID, an investor has greater control over tax liabilities and after-tax performance.

How GainsKeeper Can Help Investors Calculate Capital Gains

GainsKeeper provides automated tax lot accounting tools to help investors calculate capital gains tax.  GainsKeeper tracks investments and automatically adjusts for wash sales and corporate actions. GainsKeeper matches tax lots and calculates capital gains and losses.  It also characterizes capital gains and losses as short or long-term.  This information is then used to produce the Schedule D.