Capital Gains Treatment

Written By
Paul Tracy
Updated July 18, 2021

What is Capital Gains Treatment?

Capital gains treatment refers to whether capital gains are taxed as short-term capital gains, long-term capital gains, or in another manner.

How Does Capital Gains Treatment Work?

Let's assume you purchase 100 shares of XYZ Company for $1 per share. After three months, the share price increases to $5. This means the value of the investment has increased from $100 to $500, for a capital gain of $400.
 
Taxpayers report capital gains on IRS Schedule D, but these gains are subject to different tax rates depending on whether they are short term or long term and in some cases, depending on the type of asset. In the example above, if you sold the XYZ Company shares after a year, the IRS would consider your $400 profit a long-term capital gain and tax it at one of several lower, flat rates. However, if you sold the XYZ Company shares after just three months, the IRS would consider your $400 profit a short-term capital gain and tax that $400 at your ordinary income tax rate, which is generally higher than the long-term capital gains tax rate. This system encourages long-term investing, but there are many reasons an investor might want to sell an asset before a year has passed.
 
An investor's capital losses will sometimes offset all or a portion of his or her capital gains, lowering the investor's tax bill. There is a limit, however, to how much the investor can offset. note also that the aELKS does not treat the distributions of net realized long-term capital gains, like those from a mutual fund, as capital gains. The IRS treats those as ordinary dividends.

Why Does Capital Gains Treatment Matter?

Several factors influence capital gains treatment, including the size and timing of the capital gain, the nature of the asset, and various tax rules that apply to specific situations.  For example, special capital gains treatment applies to purchases and sales of art and collectibles, family-owned businesses, and even timber or coal. Understanding how these laws affect your investment is important.  Investors should seek the advice of a competent tax professional to understand how capital gains treatment affects you.

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