Capital gains explained

You bought a stock. That stock then surged 20 percent in value. Hooray! You now have 20 percent more cash in your pocket, right? Not so fast—don’t forget about the capital gains tax.

Ben Franklin once said that in this world nothing can be said to be certain, except death and taxes. And that applies to investing, too.

When you make money on an investment, it’s considered a capital gain, and you will need to pay a capital gains tax (with some exceptions—more on that later). Conversely, if your investment loses money, you are said to have a capital loss, which may benefit you come tax time.

All investors should have some understanding of how capital gains work so you aren’t surprised come April. Here are a few key capital gains facts to get you started.

Selling an investment typically has tax consequences. To figure out whether you need to report a gain—or can claim a loss—you need to know the cost "basis" for that investment. Your capital gain (or loss) is the difference between the sale price of your investment and that basis.

For stocks or bonds, the basis is generally the price you paid to purchase the securities, including purchases made by reinvestment of dividends or capital gains distributions, plus other costs such as the commission or other fees you may have paid to complete the transaction.

You usually get this information on the confirmation statement that the broker sends you after you have purchased a security. You, the taxpayer, are responsible for reporting your cost basis information accurately to the IRS, but your brokerage firm will provide information to help you out. 

If you held the security for less than a year, that difference (when positive) will be taxed as ordinary income. But if you held the security for a year or longer, making your profit a "long-term" capital gain, it is taxed at a special, lower tax rate.

The tax code can change, so you should check with the IRS for the current capital gains tax rate.

Capital gains (and losses) apply to the sale of any capital asset. That includes traditional investments made through a brokerage account such as stocks, bond and mutual funds, but it also includes real estate and cars.

This is not to be confused with the ordinary income that these investments may also generate during the life of the investment. For example, interest payments and rent aren’t generally considered capital gains, but are rather taxed as ordinary income.

In short: capital gains (or losses) are generally triggered by the sale of an investment. If you sell an asset within a year of buying it, any increase in its value is known as a short-term capital gain, and if you sell it a year or more after buying it, the increase is known as a long-term capital gain.

Certain investment accounts are exempt from capital gains tax or benefit from tax deferral. These accounts are called "tax-advantaged" accounts.

Tax-free accounts can include Roth IRAs and 529 plan college savings accounts, among others. Tax-deferred accounts include traditional 401(k) plans and traditional IRA accounts, among others.

For a tax-free account, you don’t have to pay a capital gains tax if you sell the investments held in those accounts within certain guidelines. For example, for a 529 plan, your earnings grow tax-free and you don’t pay capital gains tax or income tax if you sell the investments to pay for qualified education expenses.

A tax-deferred account, such as a traditional 401(k), typically benefits you in two ways. First, contributions come from your pre-tax income, reducing the amount of gross income you report to the IRS. Second, your investments grow tax-free, and your gains on those investments will be taxed as earned income at a later date (after age 59 ½). That can be a huge benefit since many people move to a lower tax bracket than the one they were in when they were in the peak of their earning years.

It’s a good idea to read up on the tax implications of any account before you invest. And remember: tax rates can change.

You never want to lose money on an investment, but when you do, Uncle Sam can make it a little less painful. When you sell an investment for less than your cost basis, the negative difference between the purchase price and the sale price is known as a capital loss. Like capital gains, capital losses are classified as either long-term or short-term.

Whereas a capital gain increases your income on your tax return, a capital loss counts as a deduction. A capital loss can be used to offset your capital gains, and thus your capital gain tax burden. For example, if you sell two stocks in a year, one at a $1,000 profit and the other at a $500 loss, you will report a net capital gain of $500 and only pay the capital gains tax on $500.

If your capital losses exceed your capital gains, the excess can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately. If your loss is more than that annual limit, you can carry over part of the loss into the next year and treat it as if you incurred it that year, according to the IRS.

While capital gains may be taxed at a different rate, they are still included in your adjusted gross income, or AGI, and thus can affect your tax bracket and your eligibility for some income-based investment opportunities.

For example, say you generally have an AGI of $38,000, which puts you in the 12 percent tax bracket. But this year you sell an investment with a capital gain of $5,000. That may change your AGI to $40,000—and push you into the next tax bracket—22 percent.

Meanwhile, say you are single and generally have an AGI of $110,000 and regularly max out your contribution to a Roth IRA. This year, however, you sell a number of investments from your normal brokerage account to fund the down payment on a house, and those investments include $15,000 of capital gains. Those capital gains would push your AGI to $125,000—and would reduce the amount you could contribute to a Roth IRA that year, as it would push you into the "phase out" income range.

Of course, there a number of factors that can impact your AGI other than capital gains. The IRS has a number of resources to help you. And you can always consult a tax professional to help you understand how your investments may impact your tax situation.