Capital Gains Tax
What is Capital Gains Tax?
A capital gains tax is a tax on the profit from selling an asset for more than you paid, owed only when the gain is realized through a sale.
A capital gain is the sale price of an asset minus its purchase price, or basis, and the tax applies to that difference rather than to the whole sale price. Gains are normally taxed only when realized, so an investor who holds an appreciating asset owes nothing until she sells; that delay is valuable because untaxed money keeps compounding. Many systems tax long-held assets at a lower rate than wages, on the argument that the gain partly reflects inflation and that the underlying corporate profits were already taxed once. Critics reply that the gap rewards income from wealth over income from work. A capital gain is not the same as dividend income, which is a payout from ongoing profits rather than a change in the asset's price.
Capital Gains Tax: a worked example
Suppose you buy 100 shares at $40 and sell them years later at $70. Your gain is ($70 − $40) × 100 = $3,000. At an illustrative long-term rate of 15%, the tax is 0.15 × $3,000 = $450, leaving $2,550. Had the same $3,000 been wage income taxed at an illustrative 32% marginal rate, the tax would be $960, or $510 more. Nothing is owed in the years the shares simply rise in value; the bill arrives only in the year you sell.
The mistake students make with capital gains tax
Many students think the tax hits the full sale price. Only the gain is taxed, so selling an asset for $70 that cost $40 puts $30 in the tax base, not $70. A second mistake is believing paper gains are taxed each year; under a realization rule, an asset that doubles and is never sold generates no capital gains tax at all.
Capital Gains Tax questions
Do you pay capital gains tax if you do not sell?
No, under a realization rule you owe nothing until you sell the asset. An investment can rise in value for many years and generate no tax bill along the way. This deferral is one reason economists say the effective tax rate on capital gains is lower than the stated rate.
Why are long-term capital gains often taxed at a lower rate than wages?
Lower long-term rates are usually defended on three grounds: part of a nominal gain is only inflation, corporate profits behind the gain may already have been taxed, and a lower rate discourages investors from locking up assets to avoid the tax. Opponents argue the gap mainly benefits households that own assets. Rate structures differ by country and change with legislation.
How is a capital gain different from a dividend?
A capital gain comes from selling an asset for more than you paid, while a dividend is a cash payout a company makes to shareholders out of profits. You control the timing of a gain by choosing when to sell; you do not control when a company declares a dividend. Many tax systems apply similar rates to long-term gains and qualified dividends, but they are separate items on a return.
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