What Is Capital Gains Tax?

Roxanna Guinan
by Roxanna Guinan, Contributor

Capital gains are profits or the difference between the original cost basis of an asset (such as stocks, bonds, mutual funds, art or real property) and the price at which it was sold.  The amount represented by the increase in value of an asset is a capital gain; if the asset lost value, the amount would be a capital loss.  Capital gains are typically taxed at rate that is less than the tax rate for ordinary income tax.  The government offers a preferential capital gains tax rate to encourage individuals and businesses to make investments that can help grow the economy.

Capital gains are subject to a tax that varies according to the type of asset, the holding period and the tax bracket of the asset’s owner.  Profits/losses on assets held by an investor for one year or less are considered short-term capital gains or losses and are taxed at the investor’s ordinary income tax rate.  Profits or losses on assets held for longer than one year are classified as long-term capital gains or losses and benefit from a lower capital gains tax rate than short-term gains.

The Tax Reconciliation Act signed into law by President George W. Bush on May 17, 2006, extended a reduction of the capital gains tax from 20% (in effect in 2003 and prior) down to 15% through 2010.  If the Obama administration does not extend the capital gains tax cuts beyond 2010, the rates will revert to the original capital gains tax rates as indicated below:

  • In 2010, the capital gains tax rate on qualified dividends and long-term capital gains is 0% for those in the 10% and 15% income tax brackets.
  • After 2010, dividends will be taxed at the taxpayer's ordinary income tax rate, regardless of his or her tax bracket.
  • After 2010, the long-term capital gains tax rate will be 20% (10% for taxpayers in the 15% tax bracket).
  • After 2010, the qualified five-year 18% capital gains tax rate (8% for taxpayers in the 15% tax bracket) will be reinstated.

The capital gains tax is a hot political issue and many people believe that raising the capital gains tax in 2011 when we have a lagging economy, record unemployment and a dismal real estate market will hurt investors even more and stymie any hopes for a recovery.