What is a capital gains tax?
– A capital gains tax is a federal tax on the profit you make when you sell a taxable asset (for example, stocks, bonds, or real estate). The tax applies when the gain is realized — that is, when you actually sell the asset — not while the asset’s price is only rising on paper (unrealized gain).
Key definitions
– Realized gain: The profit realized when you sell an asset (sale proceeds minus your cost basis and allowable adjustments).
– Unrealized gain: An increase in value that exists only on paper because you haven’t sold the asset.
– Cost basis: Generally the amount you paid for the asset, adjusted for things such as purchase fees, capital improvements (for real estate), and depreciation taken for investment property.
– Short-term capital gain: Profit on assets held one year or less; taxed at your ordinary income rates.
– Long-term capital gain: Profit on assets held longer than one year; taxed at special, generally lower rates.
– Depreciation recapture: For some real estate, prior depreciation deductions reduce your basis and some of those previously taken deductions may be taxed at a higher recapture rate when you sell.
How the tax is applied (U.S. federal, as of tax year 2025)
– Long-term capital gains are taxed at preferential rates of 0%, 15%, or 20% depending on your taxable income.
– Certain categories have special treatment. For example, net long-term gains on collectibles are subject to a maximum tax rate of 28%.
– Short-term gains are taxed at ordinary income tax rates (the same brackets that apply to wages and most ordinary income).
– Qualified dividends are taxed at the long-term capital gains rates; ordinary dividends are taxed as ordinary income.
– Gains are reported and taxed in the year the asset is sold.
Important real-estate rules (principal residence vs investment property)
– Home-sale exclusion: If you owned and used a property as your primary home for at least two of the five years before the sale, you may exclude up to $250,000 of gain ($500,000 for married filing jointly) from taxable income.
– Costs that improve the home (
) increase your adjusted basis in the property and therefore reduce any taxable gain when you sell. Keep receipts and documentation for improvements (for example: additions, new roof, major HVAC replacement) because they are the items that can be added to basis. Normal maintenance and repairs (painting, minor fixes) are not capital improvements.
Key formulas and definitions (useful checklist)
– Amount realized = Sales price − Selling expenses (commissions, legal/closing fees).
– Adjusted basis = Original cost + Capital improvements − Allowed depreciation − Certain other adjustments (like casualty loss deductions claimed).
– Gain (or loss) = Amount realized − Adjusted basis.
– Holding period: Long-term = held more than 1 year; Short-term = held 1 year or less. Long-term gains qualify for preferential capital gains rates; short-term gains are taxed as ordinary income.
Always document: purchase contracts, settlement statements, receipts for improvements, depreciation schedules for rental use, and brokerage 1099-Bs.
Common special rules and traps
– Depreciation recapture (real estate): If you claimed depreciation on rental property, part of the gain attributable to prior depreciation may be taxed differently. For most residential rental real property, “unrecaptured Section 1250 gain” is taxed at a maximum 25% rate (this is still considered a capital gain treatment rather than ordinary income). If accelerated depreciation was used for certain assets, some recapture can be taxed at ordinary income rates. Check your depreciation records and Form 4797/Form 8949 reporting.
– Like-kind exchanges (Section 1031): Prior to changes in law, many property exchanges could be tax-deferred; under current federal rules, like-kind deferral is generally limited to real property used in business or held for investment and must satisfy strict timing and identification rules to defer recognition of gain. Personal property exchanges no longer qualify.
– Wash-sale rule (stocks and securities): If you sell a security at a loss and buy a “substantially identical” security within 30 days before or after the sale, the loss is disallowed for current tax purposes and is added to the basis of the repurchased security. This prevents immediate tax recognition of the loss.
– Inherited property basis (“step-up”): Generally, property inherited from a decedent receives a basis equal to its fair market value at the date of death (a “step-up”), which often reduces taxable gain on a subsequent sale. There are exceptions for some community property states and alternate valuation elections.
– Gifts: When you receive property as a gift, you typically inherit the donor’s basis (carryover basis). Special dual-basis rules apply if the donor’s basis is greater than the fair market value at the time of the gift and the recipient later sells at a loss.
– Special asset classes:
– Collectibles (art, coins, certain precious metals) have a separate maximum federal rate (typically higher than regular long-term rates).
– Qualified Small Business Stock (QSBS) may be eligible for partial or complete gain exclusion under Section 1202 if specific conditions are met (e.g., holding period, type of business).
– State taxes: States vary greatly. Some tax capital gains as ordinary income; some offer partial exclusions; a few do not tax income at all. Always check state tax rules.
Reporting, annual
Reporting, annual filing, and practical rules (continued)
Reporting basics — forms and records
– Broker and payer reports: Brokers and other payers issue Form 1099-B or similar statements showing gross proceeds from sales. These reports may show cost basis if the broker is required to report it.
– Your tax forms: Most individual taxpayers report capital transactions on Form 8949 (Sales and Other Dispositions of Capital Assets) and summarize totals on Schedule D of Form 1040. If you received multiple 1099-Bs, you may need multiple Form 8949 entries or attach a clearly formatted substitute.
– Keep records for each transaction: purchase date and cost (basis), sale date and proceeds, commissions and fees, and documentation of adjustments (corporate actions, wash-sale disallowances). Retain these documents for several years (IRS audits can reach back).
Netting rules — step-by-step
1. Separate gains and losses by holding period:
– Short-term: assets held one year or less. Taxed at ordinary (marginal) income tax rates.
– Long-term: assets held more than one year. Eligible for preferential long-term rates.
2. Net short-term gains and losses together to get a single short-term net result.
3. Net long-term gains and losses together to get a single long-term net result.
4. Offset the two results against each other:
– If both are gains, report both as tax liability (short-term taxed as ordinary income; long-term taxed at long-term rates).
– If one is a net loss, it reduces the other. If the combined result is a net capital loss for the year, you can deduct up to $3,000 of that loss ($1,500 if married filing separately) against ordinary income; any remaining loss is carried forward indefinitely until used.
Worked numeric example — netting and deduction
Assumptions: single filer, ordinary marginal rate 22%, long-term capital gains rate 15% for relevant income.
Transactions in tax year:
– Short-term gain: $5,000
– Long-term gain: $10,000
– Long-term loss: $6,000
Step 1: Net long-term: $10,000 − $6,000 = $4,000 long-term net gain.
Step 2: Net short-term: $5,000 short-term net gain.
Step 3: No losses to offset both, so taxable amounts:
– Short-term taxable gain = $5,000 taxed at ordinary rates → tax = $5,000 × 22% = $1,100
– Long-term taxable gain = $4,000 taxed at long-term rate → tax = $4,000 × 15% = $600
Total federal tax on gains = $1,700 (before possible NIIT or state tax)
Capital loss carryover example
If instead your year showed a total net capital loss of $12,000:
– Annual deduction limit = $3,000 (for married filing jointly or single: $3,000)
– Deduct $3,000 against ordinary income this year; carry forward $9,000 to future years, where it will be applied first against future gains, then up to $3,000/year against ordinary income.
Wash-sale rule — effect and calculation
– Definition: A wash sale occurs when you sell a security at a loss and buy a “substantially identical” security within 30 days before or after that sale.
– Result: The loss is disallowed for current deduction; instead, the disallowed loss amount is added to the cost basis of the replacement shares. This defers the loss until you ultimately sell the replacement shares without triggering another wash sale.
– Practical example:
– Buy 100 shares at $50 (basis $5,000). Sell at $40 → realized loss $1,000.
– Buy replacement 100 shares within 30 days at $42. Because of wash-sale, you cannot deduct the $1,000 now. New basis for the replacement shares = $42 × 100 + $1,000 = $5,200. When you later sell the replacement shares (outside a wash-sale window), the deferred $1,000 loss will be reflected in gain/loss.
Specific identification vs. FIFO
– Method choice: When selling part of a holding, you can use specific identification
specific identification — that is, you tell your broker exactly which shares (lot, purchase date, and quantity) you intend to sell — or you can let the broker use FIFO (first-in, first-out). Below are practical details, comparisons, and steps you should follow when deciding and reporting.
How the two methods work (concise)
– Specific identification: You choose the exact lot(s) to sell. This lets you pick shares with a higher or lower cost basis to manage taxable gain or loss timing. You must identify the lot at or before the trade and get broker confirmation that they accepted your instruction.
– FIFO (first-in, first-out): If you don’t make a specific identification, the IRS and most brokers default to FIFO — the oldest shares are considered sold first. This can produce larger or smaller gains than you might prefer.
Worked numeric example
– Purchases:
– Lot A: 100 shares bought Jan 5 at $10 = $1,000 basis
– Lot B: 100 shares bought Jun 10 at $20 = $2,000 basis
– Sale: 100 shares sold Sep 1 at $15 = $1,500 proceeds
– If FIFO (oldest lot sold): basis = $1,000 → gain = $500
– If specific identification (you specify Lot B): basis = $2,000 → loss = $500
This shows how choice affects current taxable gain/loss and future basis remaining.
How to make a valid specific-identification sale (step-by-step)
1. Before or at the time of placing the sell order, tell your broker you are using “specific identification” and provide the lot details (purchase date and number of shares).
2. Place the sell order and ensure the broker’s trade confirmation explicitly lists the lot(s) sold.
3. Save trade confirmations and account statements showing the lot identification; this is your evidence if the IRS questions the transaction.
4. If the broker didn’t accept your instruction, the sale will typically default to FIFO. You can appeal, but documentation is essential.
Basis reporting categories and broker reporting
– Covered vs noncovered securities: “Covered” securities are those purchased after certain IRS dates when brokers became required to report cost basis to the IRS (dates differ by security type). Brokers automatically report basis for covered securities; for noncovered securities you must supply the basis. Always verify your broker’s statement.
– Average-cost method: For mutual funds and some dividend reinvestment plans (DRIPs), you may be allowed to use average cost per share rather than tracking each lot. Check broker and fund rules and elect the method according to IRS guidance.
Capital gains and losses: netting rules (how gains/losses are combined)
1. Compute total short-term gains and short-term losses (short-term = assets held one year or less). Net those to get a net short-term gain or loss.
2. Compute total long-term gains and long-term losses (long-term = assets held more than one year). Net those to get a net long-term gain or loss.
3. If the net short-term and net long-term results have the same sign (both gains or both losses), that’s your overall result. If they have opposite signs, offset the smaller against the larger to get a single net capital gain or loss for the year.
Example:
– Net short-term = +$1,500
– Net long-term = −$2,000
– Combined = −$500 net capital loss for the year.
Capital loss carryovers and annual offset rules (U.S. individual taxpayers)
– If your combined net capital result is a loss, individuals may deduct a limited amount of that loss against ordinary income each year and carry the remainder forward.
– As of current IRS practice, up to
$3,000 ($1,500 if married filing separately) of a net capital loss may be deducted against ordinary income each tax year; any remaining loss is carried forward to future years until used up. Carryovers retain their character (short‑term or long‑term) and are treated as capital losses in the year carried forward for netting and reporting purposes.
How to compute and report a capital loss carryover (step‑by‑step)
1. Gather year’s totals: compute net short‑term gain/loss and net long‑term gain/loss (use Form 8949