Long Term Capital Gains vs. Short Term Capital Gains
Gabe Fransen | May 17th, 2023
One of the activities that we go through when analyzing a financial plan or financial situation for folks that are looking for advice, is to review their assets. We look at everything from checking, savings accounts to real estate properties, retirement accounts and life insurance policies. Part of the analysis is to identify the cost basis of non-retirement assets. When we begin discussing our findings, folks often ask questions regarding Long Term Capital Gain, Short Term Capital Gain and Cost Basis. We like to help investors understand how these three things impact their financial plan so that when we discuss their assets, they understand the value in the recommendations we provide. With that being said, let’s jump in.
Long Term Capital Gain vs. Short Term Capital Gain
When you sell an asset for a profit, this could be stocks, real-estate, art, etc… you may have to pay capital gains taxes. The amount of tax you owe depends on how long you held the asset before selling it. If you held the asset for one year or less, the gain is considered short-term. Short-term capital gains are taxed at your ordinary income tax rate. If you held the asset for more than one year, the gain is considered long-term. Long-term capital gains are taxed at a lower rate than short-term capital gains. The exact tax rate you pay on long-term capital gains depends on your income. For most taxpayers, long-term capital gains are taxed at 0%, 15%, or 20%.
There are a few exceptions to the long-term capital gains tax rates. For example, collectibles, such as art, antiques, and jewelry, are taxed at a flat rate of 28% regardless of how long you held them.
Step Up in Basis
When you inherit an asset, the cost basis of the asset is stepped up to its fair market value on the date of the death of the original owner. This means that you will not have to pay capital gains taxes on any appreciation in the value of the asset that occurred before the death of the original owner. For example, let’s say your grandmother owns a stock that she bought for $100. When she dies, the stock is worth $200. If you inherit the stock, your cost basis will be $200. If you sell the stock for $250, you will not have to pay capital gains taxes on the $100 of appreciation that occurred before your grandmother died, just the $50 for the appreciation that occurred while you owned it.
Step up in basis can be a valuable tax benefit for heirs. It can help them avoid paying capital gains taxes on appreciation that occurred before they inherited the asset.
Long-term capital gains are taxed at a lower rate than short-term capital gains. One can assume that the reason that long-term capital gains are taxed at a lower rate is because the government wants to encourage investors to hold onto their assets for longer periods of time. This may help promote economic growth by providing investors with a reason to invest in businesses and other assets that can help to create jobs and stimulate the economy. Short-term capital gains are taxed at your ordinary income tax rate as they can be considered to be more speculative. This means that investors are more likely to sell short-term assets for profit if they believe that the price of the asset is going to go down in the near future. This can lead to market volatility and can make it difficult for businesses to plan for the future. Step up in basis can help heirs avoid paying capital gains taxes on appreciation that occurred before they inherited the asset. This can be especially helpful for heirs who inherit assets that have appreciated significantly in value.
Here are some tips for minimizing your capital gains taxes:
- Hold onto your assets for longer periods of time. This will help you qualify for the lower long-term capital gains tax rate.
- Consider the timing of when selling assets that have appreciated significantly in value as part of transfer of wealth planning. This can help you minimize your capital gains taxes by taking advantage of the step up in basis.
Consult a tax advisor to help answer specific questions about your individual needs or situation.
Internal Revenue Service Topic No. 409, Capital Gains and Losses https://www.irs.gov/taxtopics/tc409