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What Are The Differences Between Capital Gains Tax And Ordinary Income Taxes?

Scott Steinberg6-Minute Read
November 30, 2021

Curious about the difference between capital gains and ordinary income taxes? You’re not alone: Every year, millions find themselves wondering the same thing. After all, the difference between capital gains vs. ordinary income tax isn’t always obvious, but it can have a significant impact on the amount of money you owe in taxes each year.

If you’re wondering how capital gains work vs. income tax, you’re in the right place. Here we take a closer look at the difference between these taxes and their potential impact on your finances.

Capital Gains Vs. Ordinary Income Taxes: What’s The Difference?

Capital gains taxes are a favorable tax treatment that the Internal Revenue Service (IRS) and federal government have implemented. Reasons for doing so primarily revolve around encouraging investors to buy and hold capital assets (for example, stocks and real estate) while ordinary income taxes are applied to income, interest earnings and short-term capital gains.

A handy way to think about capital gains vs. income tax is to picture income tax as a federally mandated fee that’s levied on any monies that you’ve earned through your work and personal effort. Capital gains taxes are instead charged on sums that you’ve earned as a profit through the buying of an asset – like a vacation home or chunk of stock – and subsequent sale of the asset for a higher price.

Capital gains taxes further fall into two buckets based on long-term and short-term capital gains. Long-term capital gains – which are taxed at a more favorable rate – are charged on assets that you have sold after holding them for at least a year. Short-term capital gains are instead charged at the standard higher ordinary income tax rate.

As you might imagine, investors are incentivized to buy and hold long-term investments, given the potential tax savings to be recognized over time. However, it’s not uncommon if you’re day trading stocks, renovating and flipping houses or engaging in other quick-turn projects to incur short-term capital gains taxes as well.

Put simply: Ordinary income tends to include items such as wages, tips and interest income. Capital gains arise when you sell a capital asset such as a stock, home, apartment or condo for more than its purchase price, or taxable basis. If this asset is sold within 1 year of purchase, the gain is short term and is taxed at the higher ordinary income rate. If it is sold after 1 year of purchase, it is taxed at the discounted long-term capital gains tax rate instead.

Long story short: Ordinary income taxes are applied to wages and income, interest earnings, and short-term capital gains. By way of contrast, capital gains taxes are a favorable tax treatment that lowers taxes on profits made through investment activities that are designed to encourage investors to buy and hold capital assets.

Capital gains tax rates are 0% if you earn below $80,000 per year, 15% between $80,000 and $445,450, and 20% thereafter for single taxpayers and 20% if you earn over $496,600 for married spouses filing jointly.

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What Are Capital Gains?

Capital gains taxes are applied to any profits that you make on the sale of an asset. They’re designed to encourage risk-taking and non-speculative (short-term) investments. As a helpful rule of thumb, it helps to remember that capital gains apply to profits from the sale of an investment such as real estate, stocks, etc.

What’s The Difference Between Long-Term And Short-Term Capital Gains?

The difference between long-term and short-term capital gains is determined by whether an investor has held the asset for at least 1 year. Profits generated from the sale of an asset owned for less than a year are considered short-term capital gains and are treated as ordinary income.

Bearing this in mind, you’ll want to be careful when selling assets to make sure that you’re aware of the tax implications of selling too early. Prior to any sale, you’ll want to take a moment to run the numbers and see where you’ll shake out. If you don’t need to sell right away, it’s often better to wait before pursuing a transaction.

Capital Gains Vs. Ordinary Income In Real Estate

Real estate is considered a capital asset like any other. At the same time, there are also special rules that exempt the first $250,000 of the profits from the sale of a primary residence per individual and $500,000 per married couple filing jointly if the owner lived in the residence for 2 of the last 5 years.

In other words, special incentives are provided for those wishing to make real estate investments. However, be advised: If you sell your property prior to meeting the 2-years-out-of-5 mark, as a home seller, you will pay long-term capital gains rates on the entire proceeds at the 1-year mark and ordinary income rates on gains realized from the sale of the residence in the first year.

Show Me The Math: Capital Gains Taxes Calculated

Say Bob buys a chunk of stock for $5,000. A year and a half later, he sells it for $7,500. His profit margin (in this case $2,500) is considered long-term gains and taxed at a more favorable rate. Since he held it for over a year and the profit is less than $80,000, the capital gains tax rate is 0%.

Had he sold this same stock less than a year after acquiring it, it would instead be taxed at his ordinary income rate. This means it’s folded into his income taxes. Continue reading to see how the math works out.

What Is Ordinary Income?

Ordinary income refers to the monies that you’ve earned that are taxable at ordinary rates. For practical purposes, ordinary income tax is generally applied to wages, salaries, tips, bonuses, rents, interest income, royalties and other sums earned because of your efforts and labors.

The tax rates at which ordinary income is taxed vary depending on if you’re single or married, how much money you earn annually, and which income brackets you fall under.

Show Me the Math: Ordinary Gains Taxes Calculated

Say Bob’s total income for the year was $50,000. According to the IRS, portions of his income would be taxed at 10%, 12% and 22%, respectively.

If he sold his stock for $2,500 in additional income within a year, he would pay ordinary gains taxes on the money at 22% (the current tax bracket into which his income falls). This changes if he reaches his current tax bracket’s ceiling – at which point the money would fall into a higher tax bracket and a higher tax rate would be applied.

What About Capital Losses

In the same fashion that capital gains can result in additional taxes, capital losses can also balance out sums owed to the IRS and provide helpful tax benefits. Noting this, they’re often used by investors (real estate investors specifically) to offset large capital gains in a given tax year, so there are circumstances where it makes sense to sell a disappointing investment asset early.

Note that capital losses that exceed capital gains offset ordinary income. If you’re interested in learning more about how you can use capital losses to create tax advantages, consult a qualified tax professional.

Why Do Tax Planners Love Capital Gains and Losses?

Because capital losses can be used to offset capital gains, much of the work of tax planners is finding ways to balance out income and losses and reduce a taxpayer’s overall tax burden. Long-term capital gains (and losses) are important tools in their toolbox for doing so. Ironically, losses can often be just as valuable as gains depending on how you time them out.

For example: Say Bob has had a good year at work and earned $10,000 in additional bonuses. Rather than pay higher taxes on the money, he might wish to sell some underperforming stocks that he’s been holding onto for a capital loss of $5,000 to offset taxes that would otherwise be paid on half of this income.

How Do I File My Capital Gains With The IRS?

To file information concerning your capital gains with the Internal Revenue Service, you’ll want to submit Form 8949: Sales and Other Dispositions of Capital Assets for both capital gains and losses. Note that the gain or loss is then entered into your Schedule D (Form 1040).

The Bottom Line: Capital Gains Reduce Your Tax Liability Compared To Ordinary Income

The difference between capital gains taxes and ordinary income taxes is both straightforward and pronounced: Capital gains taxes are often billed at a more favorable rate for investors.

Put simply: While monies owed on short-term capital gains are calculated at ordinary income tax rates, those owed on long-term capital gains are instead charged at a significant reduction.

In short, investors can enjoy meaningful tax breaks by buying and holding assets that ordinary income earners (who typically generated cash through wages and tips) do not.

Interested in learning more about how taxes work – and where you might also be eligible to enjoy tax savings? You can find out more about preparing your tax return here.

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Scott Steinberg

Hailed as The Master of Innovation by Fortune magazine, and World’s Leading Business Strategist, award-winning professional speaker Scott Steinberg is among today’s best-known trends experts and futurists. He’s the bestselling author of 14 books including Make Change Work for You and FAST >> FORWARD.