What is capital gain and capital loss? What are the tax rates on capital gains?
Capital gain is income that arises from the sale of a capital asset (e.g. company stock, a house). Gain from the sale of securities held for investment, such as shares acquired from stock compensation, is a type of capital gain.
You control the timing of capital gains and losses by deciding when to sell the underlying asset. The taxation of capital gain from the sale of shares depends on how long the asset is held, and additional rules apply to shares acquired from incentive stock options (ISOs). Capital gains and losses may be short-term or long-term:
- short-term capital gains or losses: securities held for one year or less
- long-term capital gains or losses: securities held for more than one year
To calculate the holding period, start with the day after your acquisition date and count through the date when you sell the shares.
Tax Rates On Capital Gains
Short-term capital gains are taxed at ordinary income rates. Therefore, when your marginal tax rate changes, your short-term capital gains rate also shifts. Lower marginal tax rates mean a cut in the tax rate on short-term capital gains.
Long-term capital gains have their own tax rates:
- For most people, the tax rate on long-term capital gains is 15%.
- For people with very high incomes, the rate is 20%. In 2021, the 20% capital gains rate applies to single taxpayers with yearly taxable income of more than $445,850 and married joint filers with yearly income of more than $501,600.
- For people in the 10% or 12% income tax bracket, the capital gains rate is 0% (unless the kiddie tax applies). See the thresholds below, as eligibility for this 0% capital gains rate is not a perfect match with the income ceiling for the 12% income tax rate.
For people with annual modified adjusted gross income of more than $200,000 (more than $250,000 for married joint filers), a Medicare surtax of 3.8% applies to investment income, including capital gains. This essentially raises the top rate on capital gains to 23.8%. Because of the income thresholds outlined above, income from stock compensation can increase not only your income tax rate but also your capital gains rate, and it can trigger the Medicare surtax on investment income. Michael Kitces, a wealth advisor and financial-planning thought leader, explains in a blog commentary that a capital gains "bump zone" exists when ordinary income crowds out the favorable long-term capital gains rates.
Capital Gains Rates And Taxable Income Thresholds In 2021
|Filer status||0% tax rate on capital gains||15% tax rate on capital gains||20% tax rate on capital gains||3.8% Medicare surtax on capital gains|
|Single||Not over $40,400||Over $40,400 but not over $445,850||Over $445,850||Over $200,000|
|Joint||Not over $80,800||Over $80,800 but not over $501,600||Over $501,600||Over $250,000|
More Tax Rules
Capital losses are used to offset capital gains to establish a net position for tax purposes. Only $3,000 of net capital losses can be deducted in any one year against ordinary income, and the remaining balance is carried over to future years indefinitely. When you sell losses to net them against gains, be careful about the rules on "wash sales" if you intend to buy back the same stock.
Shares held for at least five years that are considered qualified small-business stock may be eligible for an income exclusion of up to $10 million or 10 times their basis. For the stock to qualify, the company must not have been valued at over $50 million when it issued you the shares (for more details, see the related article on this website).
For additional details on the tax rules, and for annotated examples of tax return reporting for company stock sales, visit the Tax Center. See also the FAQs on gifting and donating stock for related planning ideas involving capital gains.
You must file Form 8949 and Schedule D with your federal Form 1040 tax return for any tax year in which you have sold stock. You must complete these regardless of whether you have a gain and even if you sold option stock immediately at exercise (i.e. cashless exercise, same-day sale) or if you sold restricted stock at vesting.
On your Form 8949, you report the exercise date (vesting date for restricted stock) as your purchase date, even though your holding period does not begin until the following day. For details, see the section Reporting Company Stock Sales in this website's Tax Center.
Alert: To accurately calculate and report a gain or loss on your stock sale, you must know your cost basis.
State Capital Gains Tax
Most states tax capital gains at the same rate as ordinary income, which is good news in states without individual income tax. However, as pointed out by an article in InvestmentNews, this is "terrible news" for people who sell stock in states such as California (13.8% rate) and New York (8.8%). Some states, such as New Jersey, also do not allow capital-loss carry-forwards, making the timing of gains and losses in the same year more important than usual.
Further Resources On ISOs
As articles and FAQs in the ISO section and the Tax Center explain in detail, with plenty of examples, the calculation of capital gains for ISO stock is more complex than it is for NQSO shares and restricted stock. For instance, if you exercise ISOs and sell the stock within one year after exercise (i.e. disqualifying disposition) when the market price is lower than it was at exercise (but still above the exercise price), your full gain is ordinary income. In addition, if you pay alternative minimum tax (AMT) on the exercise of ISO stock that you hold, your capital gains calculation when you sell will differ for AMT and ordinary income tax.