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.