What Is the Capital Gains Tax?

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More people than ever are investing. When stocks, real estate and other types of investments are sold for a profit — meaning they earned the owner income because they sold at a price higher than that at which they were bought — this unique type of income is taxed based on the principle of capital gains. Capital gains isolate profits from investments and tax those profits at a rate based on the seller’s annual income.

Like most legislation related to taxes, changes to capital gains rates and other policies are often hot-button issues that get investors talking. Some of the latest news in the capital gains world is the Biden administration’s proposed capital gains rate increase that stands to impact people earning more than $1 million in capital gains. To better understand how the proposed changes — and the capital gains tax itself — impact investments, learn more about what this tax is, how it works and what changes a potential rate increase might involve.

The Basics of the Capital Gains Tax

Income is any amount of money you receive as payment for work or as profit you earn from investments, dividends and other financial products you might manage. Ordinary income, or earned income, is what you might typically receive from a salary or wages if you’re an employee or from client payments, if you’re an independent contractor. Earned income is taxed, via state and federal income taxes, at a percentage rate that’s based on the tax bracket your income level places you in. While earned income is the most common form of taxable income, it’s not the only one you might encounter — particularly if you’ve started working with investments.

Many people begin investing so they can create additional income streams to improve their financial security. When you earn a profit on an investment by selling it after its value has grown and after you’ve held onto it for a certain length of time before selling, this is also considered a form of income. And, like earned income, it’s subject to taxation — not via income taxes, however, but through the capital gains tax.

The capital gains tax is the method for taxing investment income at a federal level and in states that collect income taxes. While investment income commonly comes from selling stocks and other financial products like mutual funds, cryptocurrencies and non-fungible tokens, it also might stem from the sale of real estate, fine jewelry, cars, boats or a valuable collection. Even if you don’t invest for a living, the act of selling something for more than it was worth when you originally purchased it produces a capital gain.

Who Is Affected by Capital Gains Taxes?

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Capital gains tax affects anyone who makes income that’s not “ordinary” or earned income (primarily income from working at a job or as an independent contractor). If you sell a tangible item like a car, boat or home, you will pay capital gains tax if the item has appreciated in value. (If you sell something for less than its original purchase price, this is known as a capital loss, and it can reduce your taxable income). If you sell off stocks, bonds or cryptocurrency and they grew in value while you owned them, you’ll pay capital gains taxes on those profits. If you’re a real estate investor or day trader, you’re almost certain to encounter capital gains on some earnings, too.

There are a few caveats when it comes to determining whether or not you’ll owe capital gains taxes, however. It doesn’t always apply to real estate transactions — at least not when you’re selling your primary residence. If you’ve lived in the home for at least two of the previous five years before the date you sell the home, you’re exempt from paying taxes on the first $250,000 (if you’re a single filer) or $500,000 (if you’re a joint filer) of the capital gains amount.

Let’s look at an example. Imagine you purchased a home for $300,000 and lived in it for four years. During that time, your area’s housing market grew quickly, and you were able to sell the home for $800,000, leaving you with a capital gain of $500,000. As a single filer, you’re able to subtract the $250,000 exemption from the $500,000 earnings, leaving you with $250,000 on which you’ll need to pay capital gains taxes. If you’re in the same situation but file taxes jointly with your spouse, you’re exempt from paying capital gains taxes on any of the $500,000 profit.

Another important caveat to keep in mind when it comes to capital gains is that time is a factor in whether or not you’ll pay this type of tax. There are actually two types of capital gains: short-term and long-term. Short-term capital gains are those you’ve earned from selling assets that you owned for less than a year, and long-term capital gains are those you earn from selling items you’ve owned for a year or longer. Short-term capital gains are treated as earned income, so you’ll be taxed at the same rate as the rest of your income. The capital gains tax only applies to an investment you owned for more than one year.

What Is the Capital Gains Tax Designed to Do?

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Although some investors may debate it, capital gains taxes have sort of an equalizing effect. They take into account the unique types of profits and losses that come from investing, and the IRS doesn’t take a one-size-fits-all approach to levying capital gains taxes. There are different capital gains tax rates for different income levels. The rates are based on annual income, and there are different income limits that depend on whether you file taxes as a single person, part of a married couple or a head of household.

Based on 2022’s rates, which may change in the coming years, single individuals or married filing separately individuals earning $41,675 don’t pay any capital gains tax. Heads of households can earn up to $55,800 and married filing jointly couples can earn up to $83,350 without needing to pay capital gains taxes on those earnings. Further capital gains are taxed at 15% and 20% — and in some special cases, they may be taxed at rates higher than 20%. The IRS website includes full details about income levels and exceptions when capital gains tax rates exceed 20%.

Proposed Changes to Capital Gains Tax Rates

In late April of 2021, President Biden unveiled a $1.8 billion bill called the American Families Plan. Among other initiatives, this plan aimed to expand family medical leave, offer child care subsidies to low-income families and make summer lunch programs more extensive. To fund some elements of the plan, President Biden proposed raising the capital gains tax rate for a key group of investors.

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The increase would impact investors who have an annual income of $1 million or more. For these investors, the federal capital gains tax top marginal rate could increase to just over 43%. If a citizen who makes $5 million per year earns capital gains of $1 million, that individual could pay roughly $434,000 in capital gains tax, and this does not include state taxes.

Right now, high-income investors have a capital gains tax rate of 23.8%. That’s the 20% maximum tax plus an additional 3.8% surcharge for high-income investors that was implemented to fund the Affordable Care Act. Under President Biden’s proposed plan, high-income investors, representing around 25% of all investors, would see their taxes increase by 19.6%. This increase only applies to long-term capital gains.

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