Simple Does It: Capital Gains

Contrary to popular belief, the term "capital gain" does not refer to the newest laundry product from the makers of Gain detergent. (Okay, okay; I know that's a stretch, but you try coming up with a catchy opener for this term!) Today, we'll take a look at what capital gains (and losses) are, and how they fit in with investing in a simple, easy-to-understand manner.

Old Mr. Webster Says...

By simple definition, a capital gain occurs when something you've bought is sold at a later date for a higher value. An example: you pick up a stellar copy of the latest James Patterson thriller for around $5. After sitting on your nightstand for three months collecting dust, you decide to sell it, and someone pays you $6 for the book. The $1 difference represents your capital gain. By contrast, if the book had sold for $3 and resulted in a $2 loss, that would have been a capital loss.

Capital gains do not just apply to items, however. It is a term that applies to any asset, including investments and real estate.

The Short and Long of It

In our example above, the book you bought was sold after three months. Since the time you had this asset was less than one year, it would be considered a short term capital gain. Had you held onto the book for at least one year, then it would be known as a long term capital gain. Makes sense, right?

Here's where taxes come into play in regards to the whole capital gain topic. Whenever you "make" a capital gain, you'll have to pay taxes on this amount. If it's a short term gain, then you'll end up paying taxes at your regular tax rate. Hanging on to an item for more than a year before selling will drop your tax rate to about half.

So why do you get a break of sorts when holding onto items for longer periods of time? Think of it as Uncle Sam's way to encourage you to try out your hand at long-term investing.

This is not to say that you can't sell stocks before a year's up; you can. If you happen to make any money (aka incur a capital gain) and sell before a year's time, you'll just end up paying more taxes on the gain.

A Note About Losses

No one really likes to lose money, but in the case of a capital loss, it may translate into a bit of a tax break. When it comes time to pay Uncle Sam for the year, you can subtract a loss from a gain, which results in a smaller gain and therefore a smaller amount of taxes for you to pay.

(Note: on your tax form, the short term losses will be deducted from your short term gains, and the long term losses will be subtracted from your long term gains.)

Investing can seem daunting with all of its different terms, like capital gains. Thankfully, we here at MomVesting are working to take the "daunting" part out of investing. Stay tuned for more of our investing definitions in our new "Simple Does It" series!

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