What Is Long-Term Capital Gains Tax and How Does it Work?
When it comes to investing, understanding how taxes impact your returns is crucial, especially when it comes to capital gains. Capital gains tax is a key consideration for investors who want to make the most of their profits. In particular, long-term capital gains tax offers more favorable tax rates for individuals who hold investments for longer than a year. Whether you’re a seasoned investor or new to the world of personal finance, understanding long-term capital gains tax can help you make better decisions and optimize your tax strategy.
What Is Long-Term Capital Gains Tax?
Long-term capital gains tax is a tax applied to the profit made from the sale of an asset that’s been held for more than one year. These assets can include investments like stocks, bonds, real estate, or even collectibles such as art or antiques. When you sell an asset and make a profit, the difference between the selling price and the purchase price is considered a capital gain. However, if the asset is held for more than one year, the gain is classified as a long-term capital gain, which benefits from a more favorable tax rate compared to short-term capital gains.
Long-Term vs. Short-Term Capital Gains Tax
The main difference between long-term and short-term capital gains tax lies in the holding period of the asset before it is sold. Short-term capital gains are profits from the sale of assets that are held for one year or less. These gains are taxed at your ordinary income tax rate, which can be as high as 37%, depending on your income level. In contrast, long-term capital gains are profits from the sale of assets that are held for more than one year. These gains are taxed at a more favorable rate, which typically ranges from 0% to 20%, depending on your taxable income. Using a capital gains tax calculator can help you estimate the amount of capital gains tax you’ll owe on the sale of an asset.
Long-term capital gains are taxed differently than short-term capital gains to incentivize long-term investing, rather than encouraging quick trades. By offering lower tax rates on long-term capital gains, the government hopes to promote investment stability, contribute to economic growth, and reward investors who take a longer-term approach to building wealth.
What Is the Long-Term Capital Gains Tax Rate?
As of 2024, the tax rates on long-term capital gains are determined by your taxable income, which includes wages, business income, and other sources of income. The following are the tax rates for long-term capital gains:
Filing Status0% Rate15% Rate20% RateSingleUp to $47,025$47,026 – $518,900Over $518,900Married filing jointlyUp to $94,050$94,051 – $583,750Over $583,750Married filing separatelyUp to $47,025$47,026 – $291,850Over $291,850Head of householdUp to $63,000$63,001 – $551,350Over $551,350
Will Long-Term Capital Gains Tax Change in 2025?
For 2025, the income brackets for long-term capital gains tax rates are all increasing slightly:
Filing Status0% Rate15% Rate20% RateSingleUp to $48,350$48,351 – $533,400Over $533,400Married filing jointlyUp to $96,700$96,701 – $600,050Over $600,050Married filing separatelyUp to $48,350$48,351 – $300,000Over $300,000Head of householdUp to $64,750$64,751 – $566,700Over $566,700
Common Mistakes to Avoid With Long-Term Capital Gains
While long-term capital gains tax benefits investors, there are common mistakes that can affect your tax efficiency and investment strategy. Understanding these mistakes can help you avoid them, maximizing your returns and minimizing your tax burden.
1. Selling Too Soon
One of the most common mistakes is selling an asset before meeting the one-year holding period requirement. If you sell an asset within one year of purchasing it, the gains are classified as short-term capital gains, which are taxed at the higher ordinary income tax rates. To benefit from long-term capital gains tax rates, ensure you hold the asset for more than one year before selling.
2. Ignoring the Impact of Tax-Loss Harvesting
Tax-loss harvesting is a strategy where you sell losing investments to offset gains and reduce your overall taxable income. Many investors overlook this strategy when managing long-term capital gains, which can result in higher-than-necessary taxes on your capital gains.
3. Not Considering State Taxes
While long-term capital gains are taxed at the federal level, many states also impose their own capital gains taxes. Some states have tax rates that are identical or similar to ordinary income taxes, which can increase your tax burden. Failing to consider state-level taxes on long-term capital gains can lead to unexpected tax liabilities, especially in states with high tax rates.
4. Forgetting About Special Asset Classes
Certain assets, like real estate and collectibles, may be subject to different tax rules. For example, the sale of a primary residence may be eligible for an exclusion of up to $250,000 ($500,000 for married couples) of gain, provided certain conditions are met. Similarly, gains on collectibles, such as art or antiques, are taxed at a higher rate than other long-term capital gains. Failing to take advantage of these special rules can lead to overpaying on taxes.
5. Underestimating the Tax Impact of Investment Income
When planning for long-term capital gains, it's important to consider how your investment income will affect your overall tax situation. For instance, if your income exceeds certain thresholds, you may be subject to the Net Investment Income Tax (NIIT), an additional 3.8% tax on your capital gains. Failing to account for this extra tax can lead to an unpleasant surprise when tax season arrives.
6. Failing to Maximize Tax-Advantaged Accounts
Tax-advantaged accounts, like 401(k)s and IRAs, offer opportunities to reduce or defer taxes on your capital gains. For example, gains realized within a Roth IRA are not taxed when withdrawn, which can be a powerful tool for long-term investors. Failing to take advantage of these accounts means missing out on tax-saving opportunities that could significantly reduce your capital gains tax liability.
7. Misunderstanding the Holding Period for Mutual Funds or ETFs
Investors often assume that the holding period for mutual funds or exchange-traded funds (ETFs) is the same as for individual stocks. However, the gains from mutual funds or ETFs may be subject to different rules based on when the fund buys or sells its underlying securities. Be sure to understand the specific rules related to these funds, as distributions and sales could trigger short-term capital gains taxes even if you’ve held the fund for over a year.
Long-Term Capital Gains Are Taxed at a More Favorable Rate
Understanding long-term capital gains tax is crucial for making informed investment decisions and optimizing your tax strategy. By holding assets for over a year, you can benefit from lower tax rates, which can enhance your overall returns. However, it’s important to avoid common mistakes, such as selling assets too soon or not accounting for state taxes, to ensure you take full advantage of the tax benefits. With proper planning and awareness of the rules surrounding long-term capital gains, along with the guidance of your tax advisor, you can minimize your tax liability and make smarter investment choices that align with your long-term financial goals.
To navigate complex tax strategies such as 1031 exchanges, consulting a qualified intermediary like First American Exchange Company can help achieve compliance and maximize your benefits. Contact us today for more information.