How Do Capital Gains Taxes Work?

How Do Capital Gains Taxes Work?

Traders around the world buy and sell financial instruments to secure and increase their wealth. The profits generated by trading and investing are called capital gains. Capital gains can vary greatly depending on the size and type of the trade and it serves as the primary metric to measure the viability of trading strategies. 

Due to the popularity and ease of access to capital markets, governments around the world were quick to charge capital gains taxes on financial trading and investments. 

These capital gains taxes vary greatly in their definition and rates from country to country. However, there are a few concepts that are common between jurisdictions. 

To this day, a number of countries do not charge capital gains taxes and simply tax trading income as ordinary income, or don’t tax them at all. 

Capital gains taxes are predominantly directed at wealthy individuals, as they are the ones that participate in the financial markets the most. Therefore, institutional investors are often the main sources of capital gains tax revenue for national budgets. 

If you are a beginner trader and would like to know more about how capital gains taxes work - this Investfox guide is for you. 

Capital Gains Taxes In Trading

Capital gains taxes are taxes levied on the profits (capital gains) earned from the sale of assets such as stocks, ETFs, real estate, or other investments. 

These taxes are typically imposed by governments at various levels (federal, state, and local) and can vary significantly depending on your location and the holding period of the asset.

There are a few key considerations traders need to be aware of, such as long and short-term capital gains, tax filings, tax advantages, etc. 

Types Of Capital Gains Taxes

There are two types of capital gains taxes and depending on the time frame, traders can plan out their trading strategies to get taxed at a lower rate, as the rates of long-term and short-term capital gains are different in most jurisdictions:

  • Short-term capital gains: These are profits made from the sale of assets held for one year or less. Short-term capital gains are usually taxed at a higher rate than long-term gains, as they are considered part of your ordinary income
  • Long-term capital gains: These are profits made from the sale of assets held for more than one year. Long-term capital gains often benefit from preferential tax rates, which are typically lower than the tax rates for ordinary income

Capital Gains Tax Rates

Capital gains tax rates vary from country to country. In the United States, short-term capital gains are taxed as ordinary income and range from 10 to 37%, depending on your overall tax bracket. 

As for long-term capital gains, they are taxed at 0% up to $41,675, 15% from $41,675 to $459,750, and 20% over $459,750 when filing separately. 

When filing jointly with a spouse:

  • 0% up to $83,350
  • 15% from $83,350 to $517,200
  • 20% above $517,200 

Capital Losses

If you sell an asset for less than what you paid for it, resulting in a loss, you may be able to use that loss to offset your capital gains. This is known as a capital loss deduction. Thai deduction is typically limited to $3,000 per year. 

In some jurisdictions, you can also carry forward capital losses to offset gains in future tax years. 

Tax-Advantaged Accounts

Some trading accounts, such as Individual Retirement Accounts (IRAs) and Roth IRAs in the United States, offer tax advantages. In a Traditional IRA, gains are typically tax-deferred until withdrawal, while in a Roth IRA, qualified withdrawals are tax-free. 

These accounts have different rules and limitations, so it's important to understand how they affect your capital gains tax liability.

Reporting And Filing 

When you sell an asset and realize a capital gain, you are generally required to report this transaction on your tax return. You'll need to provide details such as the purchase price, sale price, and holding period.

Many brokerage firms provide tax documents, like Form 1099-B in the United States, to help you report your capital gains accurately. 

Key Takeaways From How Do Capital Gains Taxes Work

  • Capital gains taxes are levied by governments to tax the profit generated from the buying and selling of financial instruments, such as stocks, crypto, bonds, ETFs, etc
  • There are generally two types of capital gains taxes - short-term and long-term
  • Short-term capital gains are typically taxed as ordinary income, while long-term capital gains are taxed at a different rate 
  • Traders can claim some deductions if they incur capital losses during the accounting year 
  • In the United States, brokerages provide the Form 1099-B to clients for them to report capital gains accurately 

FAQs On How Do Capital Gains Taxes Work

How much is the federal capital gains tax?

The federal capital gains tax in the United States depends on the tax bracket. Short-term capital gains taxes are levied at the ordinary income tax rate, between 10 and 37%, while long-term capital gains taxes are between 0-20%. 

What are the types of capital gains tax?

The two types of capital gains taxes are short-term and long-term capital gains. These two types of capital gains taxes are levied at different rates. A long-term capital gains tax is levied on an investment that has been held for more than a year, while anything disposed of within a year is classified as short-term capital gains. 

Are capital gains taxes deductible?

Yes, taxpayers can deduct up to $3,000 in deductions if they incurred capital losses during the accounting year. 

Furthermore, capital gains taxes do not apply to individual retirement accounts (IRAs), which grow tax-free.