Capital Gain

What Is A Capital Gain?

A capital gain is a profit made from the price appreciation of an asset or an investment.

Put plainly, it is the profit made from selling or price appreciation of an asset or an investment where it is sold or valued at a higher price than what was initially bought for.

Capital gains have different rules and regulations between different countries. For instance, the Australian government (ATO) does not categorize profit made on bond sales as a capital gain, but bond sales in the USA (IRS) are considered under this classification.

Then there are different rules for assets owned by a business and an individual. A real estate business selling a property will not come under it, but if an individual does the same, it will come under capital gains for any profit made on sales.

It also has different rates of tax for short-term and long-term gains.

A short-term capital gain occurs when the asset is sold within a year of acquisition and generally has a higher tax rate.

Long-term capital gain occurs when the asset is sold after a year after the acquisition and mostly has a lower tax rate. 

Classifications of Capital Gain

It can be classified based on an asset's ownership duration and whether it is sold or revalued.

Based on the asset's ownership duration, it is of two types:

1. Short-term gains: It is the profit generated when an asset is sold, and the duration of ownership is less than a year. 
2. Long-term gain: It is the profit generated when the asset is sold after a long period of ownership, usually more than a year from the acquisition.

Based on if the asset is sold or revalued, it is of two types:

1. Unrealized gain: When an asset rises in value but is not sold, this rise in value is classified as unrealized gain. 
2. Realized gain: When an asset rises in value and is sold for a higher value, the gain is classified as realized gain.

Capital Gains and Taxation

Capital Gains are mostly taxed based on two bases: the asset's holding period and the type of asset. The tax rate is based on the type of asset sold and whether it was a long or short-term gain.

The short-term gain is treated as an annual income of an individual and taxed as same. In the USA, personal tax rates for individuals in 2023 range between 10% to 37% depending on their annual income.  

Income tax brackets for individuals in the US as of 2023.

Table source: 2023 Federal Income Tax Brackets (cnbc.com)

So the short-term gain is treated as the annual income of an individual and taxed as the same. 

It's the long-term gains where the advantage of investing in capital shows. Almost all governments want people to invest in capital for the long term.

To achieve this, in most cases, long-term gains are taxed at a favorable rate and have more deductions and adjustments to incentivize long-term investment.  

In the US, long-term gains are taxed at 0%, 15%, and 20% for most items. For an individual making less than $44,625 taxable income, the capital gain tax is 0%. 15% for individuals making between $44,626 - $492,300 and 20% for those making $492,300+ as taxable income annually.

Capital Gain Example

To calculate it, we need to know the initial price of the asset for which it was purchased, the cost of any upgrade or improvement made, and if there was any acquisition cost like shipping or legal fees. This will give us the final price of the asset at which it was acquired.

Then to get profit, we have to subtract this amount from the amount reserved during the sale. This profit is known as capital gain and the taxable amount.

Capital Gain = Sale price of the asset - {Purchase price of asset + Acquisition expense of the asset + Improvement or maintenance expense + transfer cost}

In some cases, there is indexation and other adjustments in some long-term asset classes.

Example 1

Let us take a look at example 1.

Person A bought a house for $900,000 in 2018. He spent $300,000 on remodeling the house. After 4 years, he wanted to sell the house; he got an offer of $3,000,000 and sold the house for the same amount. He had to pay a commission of $10,000 to the agent.

Mr. A's capital gain will come to; 

Cost of the House + Remodeling Cost + Commission = Acquisition cost 
Selling Price - Acquisition Cost = Profit 

$3,000,000 - ${900,000 + 300,000 + 10,000} = $1,790,000 

As Mr. A has sold the house and realized a profit of $1,790,000, he has to pay capital gains tax on this amount under his county's tax law. 

If he had just revalued his house and not sold, the gain of $1,800,000* valuation on his house would be unrealized gain and would not be subjected to tax. 

*calculation; when there is no sale, we will not deduct commission ($10,000), so the difference between the current value of the house is $3,000,000, and the cost of accusation plus remodeling cost of $900,000 + $3,000,000 = $1,200,000.

Example 2

Moving on to example 2.

Suppose a person purchased 200 shares of $100 each at a total cost of $20,000. Then sold 100 shares for $150 each. The gain from selling these 100 will be;

Profit = (100 x 150) - (100 x 100) = $5000 

This profit is realized profit and will be considered a taxable income.

The remaining unsold shares will be valued at $150 each, making an unrealized profit of  $5000, which is not taxable.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Capital Budgeting Best Practices
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• Equity Financing
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