Capital gains and losses: How gains, losses, and tax rates work

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How long have you held an asset?

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Selling an investment—or even your home—can trigger a tax bill. Whether you owe capital gains tax depends on what you sold, how long you owned it, and how much you gained from the sale.

Consider these scenarios:

What tax consequences do you have when you sell those stocks? What about the house? Does it matter how long you owned these assets? And what about all that money you spent improving your home?

Although these situations seem very different, they all involve selling a capital asset—and each sale can result in a capital gain or loss.

Things you own and use for personal or investment reasons are capital assets. Property for personal use includes your home, your car, and your furniture. You might also own investment securities such as stocks and bonds.

In most situations, the basis of an asset is its cost to you. This cost may have been paid in cash, or via services you provided, or maybe you took out a loan to purchase them. Extra costs you paid to buy the asset are added to your basis. Such costs could include sales tax, commissions, or transfer fees.

If you make long-term improvements to your asset, you add the cost of those improvements to its basis. The sum total of the improvements you make (less any depreciation you may have claimed against the asset) becomes your adjusted cost basis.

If you received an asset from another person because of a gift or inheritance, the basis is different. Typically, the basis for inherited property is the fair market value at the date of the owner’s death. Property received as a gift has a basis of either the donor’s adjusted basis or the fair market value of the property at the time you received it, whichever is smaller (unless you have a gain when you sell the asset; in that case, you get to use the donor’s higher basis).

But what about financial securities—stocks, bonds, and exchange-traded funds (ETFs)? For most stocks, bonds, and ETFs, your broker is required to track and report your cost basis to the Internal Revenue Service. But what about securities you bought a long time ago or over time in multiple purchases?

Note: There are special rules for mutual funds that are acquired over time. If you can’t determine which exact mutual fund shares were sold, you can choose to use what’s called the average basis (but you must tell the custodian of your fund that you’re using this method), or the standard cost basis (oldest shares are sold first).

When you sell a capital asset for more than your adjusted basis, you have a capital gain. If you sell your capital asset for less than your adjusted basis, you have a capital loss. Losses from the sale of personal property, such as furniture or your home, aren’t tax deductible. But gains and losses from sales of investment securities, such as stocks and bonds, are reflected on your tax return.

Generally, if you owned your capital asset for more than a year, the gain or loss when you sell it is considered long term. If you owned the asset for less than a year, the gain or loss is a short-term capital gain or loss. Other rules apply if you inherited your asset or received it as a gift, or if your assets are futures contracts or certain other derivatives.

Note: There are special rules for the sale of your primary residence, the biggest one being the capital gains exclusion. Assuming you’ve lived in your home for two of the last five years, you can exclude up to $250,000 in capital gains if you’re a single filer and up to $500,000 if you’re married and filing jointly. That’s why it’s important to track the capital improvements you make to the home.

The totals for long-term and short-term capital gains and losses must be calculated separately. Add together all your short-term capital gains and losses to determine your net short-term capital gain or loss. Then add together all your long-term capital gains and losses to find your net long-term capital gain or loss. Finally, add together your net short-term and long-term capital gains and losses. If you end up with a net gain, that amount will be taxable. If you have a loss, some of the loss will likely be deductible on your tax return.

Generally, the short-term capital gains you report will be taxed at the same rate as your income. The lower capital gains tax rates apply to your long-term capital gains.

Most taxpayers pay a 15% tax rate on long-term capital gains.

If your capital losses are more than your capital gains, you are allowed to deduct part of that loss on your tax return. The maximum deduction is $3,000 ($1,500 married filing separately), or up to your taxable income, if that is lower than $3,000. You can carry the loss forward to later years if you can’t use it all in one year.

You may receive capital gain distributions from mutual funds and, less commonly, ETFs. Distributions of net realized short-term capital gains are included as ordinary dividends on tax documents, rather than as actual capital gains. Capital-gains distributions are generally reported on Schedule D of Form 1040.

Keep good records of what you paid for your investments and other capital assets, as well as any costs that affect their value. Knowing your cost basis and how capital gains and losses are taxed can help you make informed decisions when it’s time to sell. But don’t let taxes be the sole reason to buy, hold, or sell an investment. Your financial goals and risk tolerance should come first.