Short-Term and Long-Term — Oblivious Investor (2024)

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

When you sell something (such as a share of stock) for more than you paid for it, you’re generally going to be taxed on the increase in value. This increase in value is known as a “capital gain.”

The amount of gain is calculated as the proceeds received from the sale, minus your “cost basis” in the asset.

What is “Cost Basis”?

In most cases, your cost basis in an asset is simply the amount that you paid for that asset, including any brokerage commissions that you paid on the transaction.

EXAMPLE: Lauren buys a share of stock for $250, including brokerage commissions. She owns it for two years and then sells it for $400. Her cost basis is the amount she paid for it: $250. Her gain will be calculated as follows:

$400 (proceeds from sale)
– $250 (adjusted cost basis)
= $150 (capital gain)

Long-Term Capital Gains vs. Short-Term Capital Gains

The rate of tax charged on a capital gain depends upon whether it was a long-term capital gain (LTCG) or a short-term capital gain (STCG). If the asset in question was held for one year or less, it’s a short-term capital gain. If the asset was held for greater than one year, it’s a long-term capital gain.

STCGs are taxed at normal income tax rates. In contrast, LTCGs, are taxed at the same rates as qualified dividend income.

That is, for 2023, LTCGs are taxed at a 0% rate if they fall below $44,625 of taxable income ($89,250 if you’re married filing jointly). They are taxed at a 15% rate if they fall above the 0% threshold but below $492,300 ($553,850 if married filing jointly). And they are taxed at a 20% rate if they fall above the 15% threshold.

An important takeaway here is that if you’re ever considering selling an investment that has increased in value, it might be a good idea to think about holding the asset long enough for the capital gain to be considered long-term.

Note that a capital gain occurs only when the asset is sold. This is important because it means that fluctuations in the value of the asset are not considered taxable events.

EXAMPLE: Beth buys ten shares of a company at $25 each. Five years later, Beth still owns the shares, and the price per share has risen to $45. Over the five years, Beth isn’t required to pay any tax on the increase in value. She will only have to pay a tax on the LTCG if/when she chooses to sell the shares.

Taxation of Mutual Funds

Mutual funds are collections of a large quantity of other investments. For instance, a mutual fund may own thousands of different stocks as well as any number of other investments like bonds or options contracts.

Each year, each mutual fund shareholder is responsible for income tax on her share of the net capital gains realized by the fund over the course of the year. (Each shareholder’s portion of the gains will be reported to her annually on Form 1099-DIV sent by the brokerage firm or fund company.)

What makes the situation counterintuitive is that, in any given year, the capital gains realized by the fund could vary significantly from the actual change in value of the shares of the fund.

EXAMPLE: Deborah buys a share of Mutual Fund XYZ on January 1 for $100. By the end of the year, the investments that the fund owns have (on average) decreased in value, and Deborah’s share of the mutual fund is now worth $95.

However, during the course of the year, the mutual fund sold only one stock from the portfolio. That stock was sold for a short-term capital gain. Deborah is going to be responsible for paying tax on her share of the capital gain, despite the fact that her share in the mutual fund has decreased in value.

Note how even in years when the value decreases, it’s possible that the investors will be responsible for paying taxes on a gain. Of course, the opposite is also true. There can be years when the fund increases in value, but the sales of investments within the fund’s portfolioresult in a net capital loss. And thus the investors have an increase in the value of their holdings, but they don’t have to pay any taxes for the time being.

Capital Gains from Selling Your Home

Selling a home that you’ve owned for many years can result in a very large long-term capital gain. Fortunately, it’s likely that you can exclude (that is, not pay tax on) a large portion — or even all — of that gain.

If you meet three requirements, you’re allowed to exclude up to $250,000 of gain. The three requirements are as follows:

1. For the two years prior to the date of sale, you did not exclude gain from the sale of another home.
2. During the five years prior to the date of sale, you owned the home for at least two years.
3. During the five years prior to the date of sale, you lived in the home as your main home for at least two years.

To meet the second and third requirements, the two-year time periods do not necessarily have to be made up of 24 consecutive months.

For married couples filing jointly, a $500,000 maximum exclusion is available if both spouses meet the first and third requirements and at least one spouse meets the second requirement.

EXAMPLE: Jason purchased a home on January 1, 2021. He lived there until May 1, 2022 (16 months). He then moved to another city (without selling his original home) and lived there until January 1, 2023. On January 1, 2023 Jason moved back into his original home and lived there until October 1, 2023 (9 months) when he sold the house for a $200,000 gain.

Jason can exclude the gain because he meets all three requirements. The fact that Jason does not have 24 consecutive months of using the home as his main home does not prevent him from excluding the gain.

Capital Losses

Of course, things don’t always go exactly as planned. When you sell something for less than you paid for it, you incur what is known as a capital loss. Like capital gains, capital losses are characterized as either short-term or long-term, based on whether the holding period of the asset was greater than or less than one year.

Each year, you add up all of your short-term capital losses, and deduct them from your short-term capital gains. Then you add up all of your long-term capital losses and deduct them from your long-term capital gains. If the end result is a positive LTCG and a positive STCG, the LTCG will be taxed at a maximum rate of 20%, and the STCG will be taxed at ordinary income tax rates. If the end result is a net capital loss, you can deduct up to $3,000 of it from your ordinary income. The remainder of the capital loss can be carried forward to deduct in future years.

EXAMPLE 1:In a given year, Aaron has:
$5,000 in short-term capital gains,
$3,000 in short-term capital losses,
$4,000 in long-term capital gains,and
$2,500 in long-term capital losses.

For the year, Aaron will have a net STCG of $2,000 ($5,000-$3,000) and a net LTCG of $1,500 ($4,000-$2,500). His STCG will be taxed at his ordinary income tax rate, and his LTCG will be taxed at a maximum rate of 20%.

EXAMPLE 2:In a given year, Sandra has:
$2,000 in short-term capital gains,
$3,500 in short-term capital losses,
$3,000 in long-term capital gains, and
$5,000 in long-term capital losses.

Sandra has a net short-term capital loss of $1,500 and a net long-term capital loss of $2,000. So her total capital loss is $3,500. For this capital loss, she can take a $3,000 deduction against her other income, and she can use the remaining $500 to offset her capital gains next year.

So what happens when you have a net gain in the short-term category and a net loss in the long-term category, or vice versa? In short, you net the two against each other, and the remaining gain or loss is taxed according to its character (that is, short-term or long-term).

EXAMPLE 1: In a given year, Kyle has:
$5,000 net short-term capital gain and
$4,000 net long-term capital loss.

Kyle will subtract his LTCL from his STCG, leaving him with a STCG of $1,000. This will be taxed according to his ordinary income tax bracket.

EXAMPLE 2:In a given year, Christopher has:
$3,000 net short-term capital loss and
$6,000 net long-term capital gain.

Christopher will subtract his STCL from his LTCG, leaving him with a LTCG of $3,000. This will be taxed at a maximum of 20%.

EXAMPLE 3: In a given year, Jeremy has:
$2,000 net short-term capital gain and
$3,000 net long-term capital loss.

Jeremy will subtract his LTCL from his STCG, leaving him with a $1,000 LTCL. Because this is below the $3,000 threshold, he can deduct the entire $1,000 loss from his ordinary income.

EXAMPLE 4:In a given year, Jessica has:
$2,000 net long-term capital gain and
$4,000 net short-term capital loss.

Jessica will subtract her STCL from her LTCG, leaving her with a $2,000 STCL. Because this is below the $3,000 threshold, she can deduct the entire $2,000 loss from her ordinary income.

Simple Summary

• If an asset is held for one year or less, then sold for a gain, the short-term capital gain will be taxed at ordinary income tax rates.
• If an asset is held for more than one year, then sold for a gain, the long-term capital gain will be taxed at a maximum rate of 20%.
• If you have a net capital loss for the year, you can subtract up to $3,000 of that loss from your ordinary income. The remainder of the loss can be carried forward to offset income in future years.
• Mutual fund shareholders have to pay taxes each year as a result of the net gains incurred by the fund. This is unique in that taxes have to be paid before the asset (i.e., the mutual fund) is sold.
• If you sell your home for a gain, and you meet certain requirements, you may be eligible to exclude up to $250,000 of the gain ($500,000 if married filing jointly).