A capital asset is “significant pieces of property such as homes, cars, investment properties, stocks, bonds, and even collectibles or art” (Investopedia). Capital gains are the profit in the sale of the capital asset.
When the capital assets are sold at a higher price than they were purchased, they are considered realized capital gains.
An example of unrealized capital gains is a stock in your portfolio that has increased in value since you bought it(you have not sold it yet).
There are two types of capital gains
Short Term Capital Gains: Profits from selling capital assets that you have held for a year or less
Long Term Capital Gains: Profits from selling capital assets that you have held for a year or more
Tangent: Progressive Tax System
Let us define Effective Tax Rate as the percentage of your annual income that you pay in taxes.
Progressive tax system imposes a higher effective tax rate as income increases. This is done with a tax bracket system, something that can be confusing.
Below is the Federal Income Tax brackets
Let us calculate the federal tax $ amount that someone would pay on $500,000 of income.
You can think of each tax bracket as a bucket. The tax rate is applied to the amount that is filled up in the bucket. In this case, the first 5 buckets are filled up completely, meaning the corresponding tax rate is applied to the dollar amount that falls within the tax bracket.
In the 6th bracket, however, 70 % of the bucket is filled up, or $256,275. This amount is taxed at a rate of 35%.
The effective tax rate of making $500,000 in 2024 is 29.07%.
Section: Short Term Capital Gains
First you calculate the total taxable income, including wages, interest, dividends, and both types of capital gains.
The bucket system above is used with the same rates shown in Table 1 above.
Section: Long Term Capital Gains
First you calculate the total taxable income, including wages, interest, dividends, and both types of capital gains.
The bucket system is used except with the below rates.
(Intuit)
Section: Additional Comments
The marginal tax rate can be defined as the amount of additional tax you pay for every additional dollar of income (Investopedia).
The marginal tax rate is the rate that you pay in the last bucket that your income pours into.
For large amounts of money, the marginal tax rate will be higher than the effective tax rate.
The above charts are federal rates. State rates also apply and vary. In Illinois, for example, there is a flat income tax rate of 4.95%. All capital gains are taxed as ordinary income, using the same rates and brackets as the regular state income tax.
Section: Further Study
How do capital losses affect taxes?
What are the nuances for these rules for different types of assets, like real estate?
How do people game the system?