Capital gains: Definition, Overview & FAQ

What is a capital gain?

Definition: A capital gain is the profit earned by an investor when they sell a capital asset for more than the original purchase price. The gain equals the difference between the asset’s selling price and its original acquisition price.

Types of capital gains

There are two primary types:

1. Short-term 

Short-term capital gains are profits realised from the sale of a capital asset held for one year or less. These gains are often taxed at the individual’s ordinary income tax rate, which is usually higher than the tax rate on long-term capital gains. The tax rate might change depending on an individual’s income level.

2. Long-term 

Long-term capital gains are the earnings realised from the sale of a capital asset held for longer than a year. These gains often benefit from lower tax rates than short-term capital gains. The particular tax rate for long-term capital gains is determined by the individual’s taxable income and filing status. Long-terms are taxed at different rates in several jurisdictions, ranging from 0% to 20%.

How is capital gain calculated?

Profits from sales are computed by deducting the property’s acquisition price (basis) from its selling price. Basis adjustments and gains can be used to offset losses and minimise tax burden.

In brief, what is necessary to mention is:

Determining the purchase price (basis): The basis is the original cost of the property, including any related costs such as commissions or fees.

Determining the sale price: The sale price is the amount for which the property is sold, including all associated selling costs.

Calculation of capital gain:

Formula: Capital Gain = Sales Price – Purchase Price

Example: If an asset was purchased for $1,000 and sold for $1,500, the capital gain is $500.

Adjusting the base

Improvements and extra costs: Significant improvements can be factored into the base cost.

Depreciation: For assets like rental homes, previously recognised depreciation might diminish the basis.

Net capital gains

When numerous assets are sold, each asset’s capital gain or loss is calculated separately and then summed together to determine the total capital gain.

Compensation for gain and loss

Capital losses: If the property is sold for less than the purchase price, there will be a capital loss.

Netting process: Capital losses can counter capital gains. If losses exceed gains, they can typically be carried over to future years.

Calculation example

Purchase: Purchase of shares for £2,000

Sale: Sale of stock for £3,000

Capital gain: £3,000 (sale price) – £2,000 (purchase price) = £1,000 capital gain.

How do capital gains influence investment decisions?

Capital gains have a significant impact on how investors manage their portfolios. There are several key concerns.

• Tax considerations: Long-term investments are generally preferred by investors who want to take advantage of reduced tax rates on long-term capital gains rather than higher rates on short-term gains.
• The selling time frame is: By owning a property for longer than a year, investors might delay selling it in order to qualify for long-term capital gains taxes.
• Rebalancing: Regular portfolio rebalancing might result in capital gains. Investors must examine the tax implications of selling higher-valued assets.
• Tax loss harvesting: Investors can sell losing investments to offset gains on winning ones, lowering their overall tax liability.
• Asset allocation: Using tax-efficient asset allocation will help you maximise net after-tax returns. For instance, putting high-growth assets in tax-advantaged accounts.
• Long-term investors may prefer to hold assets in order to avoid short-term capital gains taxes, while short-term investors may accept a greater tax burden in exchange for instant cash.
• Changes in tax rules might have an impact on investment strategies.

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