Capital Gain Definition
Capital Loss Definition
What is a Capital Investment?Capital gains are profits you earn through buying and selling capital assets. Capital assets include things such as stocks, mutual funds, bonds, real estate, precious metals, coins, fine art, and other collectibles. Wages, interest, and dividends are considered ordinary income, not capital gains income.
No Capital Gains on Tax-Deferred InvestmentsMany people invest in stocks, bonds, and mutual funds through a tax-deferred retirement account. Individual Retirement Accounts (IRA), Roth IRA, and 401(k) plans are examples of tax-deferred accounts. Your investment profits in tax-deferred accounts are not reported as capital gains. Instead, income from these accounts is tax-deferred until the money is withdrawn, and then the income is taxed as ordinary income. (Withdrawals from a Roth IRA may be tax-free if you meet certain requirements.)
Roth IRA Essentials
Traditional IRA Essentials
Investment Record-KeepingInvestors need to keep track of all their investments. This information is essential for calculating the amount of capital gain you have. You must know what you bought, how much you invested, your brokerage fees and commissions, and when you bought the investment. You must also know when you sold the investment, for how much, and any fees or commissions you paid to sell the investment. You may want to use a spreadsheet or personal finance software to keep track of this information. Personal finance programs can provide more robust investment tracking features than a spreadsheet. Your broker might also have tools for tracking cost basis, gains and losses. You should also retain any reports and trade confirmations as a backup. Annual reports from your broker are especially helpful, and these should be kept along with your other tax-related documents.
If you are going to use a spreadsheet to track your investments, here's a suggested Capital Gains Spreadsheet Format.
Calculating Capital GainsYou calculate profits or losses on each investment you make. Here's the formula for calculating your profit or loss on a single investment:
- Selling price
- Minus Selling fees & commissions
- Minus Buying fees & commissions
- Minus Purchase price
- = Profit (or Loss if negative)
Here's an example of a capital gain. Mary bought 10 shares of XYZ stock at $100 per share (for a $1,000 purchase price). She paid a commission to her stock broker of $25. A year later, Mary sold all 10 shares at $120 per share (for a selling price of $1,200). Again, she paid a brokerage commission of $25. Here's how her capital gains are calculated:
- Selling price: $1,200
- Minus Selling commission: -$25
- Minus Buying commission: -$25
- Minus Purchase price: -$1,000
- = Capital Gain of $150.
On the tax forms, there's no place to put information about fees and commissions. So the easiest thing to do is to add all commissions, fees, and the purchase price together into one figure called "cost basis." Cost basis is calculated as follows:
- Purchase price
- Plus Purchase commissions and fees
- Plus Selling commissions and fees
- = Cost Basis
And that gives us a simple capital gain formula:
- Selling Price
- Minus Cost Basis
- = Capital Gain or Loss
Federal Tax Forms Relating to Capital GainsStarting with tax year 2011, capital gains are reported using Schedule D and Form 8949. This is a major change from previous years when just the Schedule D was used.
All the details regarding individual trades are reported on Form 8949, and totals from Form 8949 are then summarized on Schedule D and then transferred to Form 1040. Form 8949 is organized much like a spreadsheet, with all the essential information about each investment you sold during the year. Capital gain or loss is reported for each transaction. Then your total gains or losses are figured. You will have either a net profit or a net loss from all your trades. There are special rules for capital losses, such as annual limitations on capital losses and Wash Sale Rules.
Tax Treatment Capital GainsCapital gains are taxed differently, depending on what kind of capital asset you invested in and depending on how long you held the asset. First, we'll discuss holding periods, and then look at different types of capital assets.