In order to understand the difference between short-term and long-term capital gains, it is first necessary to understand what capital gain is. A capital gain refers to a profit that you make when you sell an asset – usually shares of stock, bonds, or other investments. When you buy an asset like shares of stock from a company, the price and value may fluctuate over time. Once you sell the shares for a price higher than what you paid for them, then you have made a capital gain.
Now there are two main types of capital gain, i.e short-term and long-term capital gain. In this post, I will show you the difference between these two.
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What is Short-Term Capital Gain?
A short-term capital gain is a profit that results from the sale of an asset held for two to three years or less. Short-term capital gains are taxed at the same rate as ordinary income.. In short-term capital gain, the tax rates are applied according to the taxpayer’s income bracket. The assets are known as capital assets, which include stocks, bonds, and real estate.
Moreover, a short-term capital gain is realized when an investor sells a security for more than the purchase price. For example, if an investor buys a stock for $10 and sells it later for $12, the $2 profit is considered a short-term capital gain.
In order to calculate your short-term capital gain, you must first determine your cost basis. Your cost basis is the original price you paid for the asset, plus any commissions or fees associated with the purchase. Once you have determined your cost basis, you simply subtract it from the selling price of the asset to determine your gain.
For example, let’s say you purchased a stock for $1,000 and sold it one year later for $1,500. Your short-term capital gain would be $500 ($1,500 selling price – $1,000 cost basis).
Tax Rates
Short-term capital gains are taxed at your marginal tax rate, which is the rate you pay on your last dollar of income. For most people, this is their ordinary income tax rate. The current marginal tax rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Three Benefits of Short-Term Capital Gain
There are a few key benefits to short-term capital gains that make them appealing to investors.
- First, short-term capital gains are taxed at a lower rate than long-term capital gains. This is because the government wants to encourage people to invest in the long term.
- Second, you can use short-term capital gains to offset other investment income that is taxed at a higher rate. This can help to reduce your overall tax bill.
- Third, you can take advantage of market fluctuations by selling investments that have increased in value over a short period of time. This can be a great way to make money if you know when to sell.
What is Long-term Capital Gain?
Long-term capital gain is the profit you earn from selling an asset that you have held for more than three years. The IRS taxes long-term capital gains at a lower rate than short-term gains, which are profits earned from selling an asset held for one year or less.
To calculate your long-term capital gain, you will need to know the purchase price of the asset and the sales price. subtract the purchase price from the sales price to find your gain. If the result is a positive number, then you have a capital gain. If the result is a negative number, then you have a capital loss.
Tax Rates
Your tax bracket determines the tax rate on long-term capital gains. For example, in 2020, taxpayers in the 10% and 12% brackets pay 0% on long-term gains, while those in the 22%, 24%, 32%, 35%, and 37% brackets pay 15%. Higher earners pay 20%.
You can avoid paying taxes on your long-term capital gains if you reinvest them into a Qualified Opportunity Fund (QOF). A QOF is an investment vehicle that allows you to defer paying taxes on your gains until you sell or exchange your investment, or until December 31, 2026 – whichever comes first.
Three Benefits of Long-Term Capital Gain?
The three benefits of long-term capital gain are:
- Taxes: Long-term capital gains are taxed at a lower rate than short-term capital gains. In fact, they may not be taxed at all if you’re in the 10% or 15% tax bracket.
- Compounding: One of the biggest advantages of long-term investing is compound interest. When you reinvest your profits and let them grow over time, your returns start to snowball — which can help you reach your financial goals more quickly.
- Peace of mind: Another advantage of long-term investing is that it can help take the emotion out of decision-making. When you have a long time horizon, you’re less likely to make impulsive decisions based on short-term market fluctuations.
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Main Difference
The main difference between short-term and long-term capital gains is the amount of time you hold onto the asset. With short-term capital gains, you’re looking at a much shorter holding period — usually just a matter of months. On the other hand, long-term capital gains refer to assets that you’ve held onto for at least a year (and sometimes much longer).
Comparison Table
The following table shows the exact comparison between short-term vs long-term capital gain.
Key Difference between Short-term and Long-term Capital Gain
- Short-term capital gains occur when an assesses owns the profit from the sale of a capital asset for less than 36 months. On the other hand, when the transferred asset is kept by the assessee for more than 36 months, the gain arising from such transfer is referred to as a long-term capital gain.
- Short-term capital gains are taxed at your marginal tax rate, which could be as high as 37%, while long-term capital gains are taxed at a maximum of 20%.
- Short-term capital gains are realized when you sell an asset that you’ve held for one year or less, while long-term capital gains are realized when you sell an asset that you’ve held for more than one year.
- Short-term capital gains are subject to recapture rules if the asset is sold at a gain within two years of purchase. On the other hand, long-term capital gains are not subject to these rules.
- Finally, short-term capital losses can only offset short-term capital gains. Whereas, long-term losses can offset both short and long-term gains.
Conclusion
The main distinction between short-term and long-term capital gains is the length of time that you have held the investment. Short-term capital gains are realized when you sell an investment that you have held for one year or less, while long-term capital gains are realized when you sell an investment that you have held for more than one year. Long-term capital gains are subject to lower tax rates than short-term capital gains, so it’s generally advantageous to hold onto investments for longer periods of time in order to realize the lower tax rate.
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