Long-Term Capital Gains vs. Short-Term Capital Gains (and Taxes)

Investing and trading are both great way to build wealth. However, success in either of these avenues also becomes a source of capital gains. When you sell an investment at a profit, you subsequently are required to pay taxes on the income generated by that investment. This is what is referred to as capital gains taxes, typically levied at rates lower than your top marginal income-tax rate. The mechanics of capital gains are relatively simple, but understanding the difference between short-term and long-term capital gains can save you thousands as you navigate the optimal ways to generate income.

A lot of investors and traders, unfortunately, don't have a complete understanding of capital gains taxes and how these taxes can impact profit margins. To a large degree, capital gains tax is a topic that generates a lot of confusion and most people prefer to avoid thinking about taxes altogether. The simple mention of capital gains taxes related to long-term investments can cause traders to completely disregard any long-term objectives and focus only on short-term gains. For this reason, many people shy away from buying assets that could earn them significant capital gains if held for more than a year. In reality, however, you can implement tax planning strategies to help you mitigate capital gains taxes.

This article will cover the following topics:

• What are capital gains? What is a capital gains tax?
• What is the difference between long-term and short-term capital gains?
• Are long-term capital gains taxed differently than short-term capital gains?
• How does my state of residence impact capital gains tax?

What are Capital Gains? What is a Capital Gains Tax?

Capital gains are generally defined as the profits received from selling a capital asset – or an investment – such as stock market assets or property. The capital gains tax is a form of double taxation, which means after the profits from selling the asset are taxed once; a double tax is imposed on those same profits.

While it may seem unfair that your earnings from investments are taxed twice, there are many reasons for doing so. One example defense for capital gains tax is that the double taxation encourages investors to reinvest those profits and put that new money back into the economy.

The capital gains tax is a tax applied only to the profit from an investment after the investment has been sold. When stock shares or any other taxable assets are sold, the capital gains (or profits) are referred to as having been "realized." Capital gains taxing does not apply to profits that have not yet been sold, or realized.

Your capital gains tax bill is calculated based on your annual income. The capital gains tax is applied when you sell stocks, options, bonds, mutual funds, precious metals, real estate, and other properties. Please remember, the capital gains tax doesn't apply to unsold investments or "unrealized capital gains." Profit from shares will not incur capital gains taxes until the assets are sold, regardless of the current value of the position.

Long-Term Capital Gains vs. Short-Term Capital Gains

The distinction between long-term and short-term capital gains is highly relevant for many investors and traders. This is because ordinary income earned through everyday wage work is taxed higher than long-term capital gains.

What's the difference between a long-term capital gain and a short-term capital gain? While both are taxed at different rates, there is actually no difference in how the capital gains are calculated. Both capital gains refer to capital gains on the sale of an asset, such as real estate or shares of stock.

Any profit you realize from the sale of property or stock market assets held for one year or less is considered a short-term capital gain. Long-term gains must come from positions held for more than one year before they can be sold. If an asset is held for under a year and closes with a profit, the trader will incur taxes consistent with short-term capital gains (assuming other requirements like substantial ownership and holding period requirements are met).

You know that investing in stocks can be a great avenue to grow your personal wealth. But if you're looking to sell the stocks you've been holding onto for a while, you might find this surprising. You could potentially save tens of thousands! If you are willing to hold on to your stock for a few more days, weeks, months, or years before you sell it, you could save significantly on capital gains taxes.

In general, investors and traders prefer to sell holdings that have appreciated, hoping to take advantage of the lower long-term capital gains tax rate. However, it might help to know how each tax rate works and whether or not there is any way to pay less taxes -- especially if you are looking to make a retirement account contribution.

One of the most significant advantages of owning stocks is that when you sell your shares for a profit, you pay taxes at just a 15% long-term capital gains rate rather than at your total marginal tax rate. However, if you've sold shares of stock within a year of purchasing it, and you may find yourself being hit with higher-tax rate from the 35% or 40% tax brackets. Known as the alternative minimum tax (AMT), short-term capital gains can raise your taxes even if you are in the 25% tax bracket!

According to the Internal Revenue Services website, here is a breakdown of the difference capital gains tax rates for short-term and long-term capital gains based on the amount gained.

How do Capital Gains Taxes Differ by State?

Tax law is incredibly complex and constantly changing. Tax law incorporates so many nuances that can be difficult to understand at first glance. While capital gains tax is pretty straightforward in most instances, some aspects may remain confusing. Every U.S. state has a different income tax code and capital gains tax.

The following states do not have income taxes and, therefore, do not have or have completely different capital gains taxes:

• Alaska
• Florida
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

Additionally, the states of New Mexico, Colorado, and Nevada do not have any capital gains tax. Finally, Montana currently offers a credit that will offset any capital gains tax potentially incurred. As for the other thirty-eight U.S. states, they all have state capital gains taxes. Before you count your stacks of profit, please be sure to refer to the IRS or local governments for total percentages. 

What do the Tax Experts Think?

We sat down with Kenneth Rubinstein, Counsel at Gallet Dreyer and Berkey, where his practice focuses on asset protection, tax law, and trust & estate planning.