How Holding Periods Affect Capital Gains Tax

Joshua Kennon is an expert on investing, assets and markets, and retirement planning. He is the managing director and co-founder of Kennon-Green & Co., an asset management firm.

Michael Boyle is an experienced financial professional with more than 10 years working with financial planning, derivatives, equities, fixed income, project management, and analytics.

Capital gains are profits you earn when you sell an investment for more than you paid for it. The amount of tax you will pay on your profit depends on whether you have a short- or long-term gain. The total capital gains tax you pay will mostly depend on how long you have had the investment.

People with long-term investments tend to pay lower taxes on them than they do for short-term gains. Although tax rates tend to change over time, holding periods stay the same. Long-term holdings are those owned by the investor for over a year, and short-term holdings are those owned for less than a year.

The IRS uses the trade date to determine your buy or sell date. That is the day you asked your broker to buy or sell your investment or you executed the trade via an online trading platform or a robo-advisor. The IRS does not consider the settlement date, which is the day when the investment changes hands, as the trade date.

Short-Term Capital Gains

Some people will buy and sell stocks on a regular basis as the market goes up and down. Assets sold, transferred, or disposed of for a profit after being held for less than a year are subject to the highest capital gains taxes.

Most often, the gain will be taxed at your personal income rate. This includes your earned income plus your capital gains. In some cases, the capital gains tax can be almost twice as much as the levy on long-term gains.

Long-Term Gains of Less Than Five Years

The IRS considers assets held for longer than one year to be long-term investments. The long-term capital gains tax rates are 0%, 15%, and 20%, depending on your income tax bracket. These rates are typically much lower than the ordinary income tax rate. However, the Biden administration has proposed changes to how the capital gains tax is determined. If the plan becomes law, those making more than $1 million a year could be taxed at a new, higher rate of 39.6%, regardless of how long the assets were held.

Originally, there was a sunset provision for these capital gains tax rates to expire at the end of the fiscal year 2008. In 2006, Congress passed a two-year extension through the fiscal year 2010 to keep those good rates in place. There are three exceptions to the normal capital gains rates:

• The gains from qualified small business stock are taxed at a maximum 28% rate.
• The net gains from selling valued items, such as coins or art, are taxed at a maximum 28% rate.
• Part of any net capital gain from selling Section 1250 real property is taxed at a maximum 25% rate.

How Your Investment Choices Can Affect Your Taxes

The tax code clearly favors people who hold on to their assets for longer amounts of time. This advantage makes it easier for patient investors to build wealth. The large capital gains tax reduction for long-term investments is one of the reasons many people tend to favor the buy-and-hold approach. For instance, if someone in the 35% tax bracket invests $100,000 in a stock and sells it six months later for $160,000, they make a 60% profit. The investor would owe $21,000 in taxes on their $60,000 gain, leaving them with only a $39,000 profit.

Imagine if the same person were to invest $100,000 in a stock and sell it one year later for $150,000. That would be a 50% profit. They would owe capital gains taxes of $7,500, leaving them with a net profit of $42,500.

Despite the fact that the return was 10% lower in the second sale, the investor ended up with nearly 9% more money. The lesson is that capital gains taxes should be a serious consideration when you want to sell an asset.

Key Takeaways

• Short-term capital gains are applied to investments you hold for less than a year. They are usually taxed at your personal income rate.
• Long-term capital gains are taxed at 15% for those in higher tax brackets. They are taxed at 5% for those in lower tax brackets. There are exceptions for some investment types.
• Value investors tend to favor the buy-and-hold approach in order to reap the tax benefits.
• Always take the capital gains tax rate into account when making the decision to sell investments.