Capital Gains Vs. Ordinary Income Tax

Every year millions of taxpayers find themselves wondering what the difference is between capital gains and ordinary income taxes. The difference between the two isn’t necessarily obvious, but it can have a significant impact on the amount of money you owe in taxes.

If you’re one of the millions wondering how capital gains work versus income tax, you’re in the right place. In a nutshell, capital gains taxes are applied to the profit made from selling a capital asset, such as stocks or real estate. Ordinary income taxes are applied to certain income and short-term capital gains.

We’ll take a closer look at the difference between capital gains tax and income tax and their potential impact on your tax bill.

What Are Capital Gains?

Capital gains taxes are applied to the profits from selling a capital asset, like your home, for instance. They’re designed to encourage people to invest in long-term assets and discourage short-term investments. Ordinary income taxes are applied to income – everything from wages to interest earnings – and short-term capital gains.

What’s The Difference Between Long-Term And Short-Term Capital Gains?

The difference between long-term and short-term capital gains is how long the asset was held before it was sold. Profits generated from the sale of an asset owned for less than a year are considered short-term capital gains and are treated as ordinary income.

That means you should keep the tax implication of selling too early in mind before selling an asset. Before the sale, run the numbers to see how much selling may cost you. If you don’t need to sell right away, it’s often better to wait and hang on to the asset.

What Is Ordinary Income?

Ordinary income defines types of income that are taxable at ordinary rates. Ordinary income tax applies to:

• Wages
• Salaries
• Tips
• Bonuses
• Rental income
• Interest income
• Royalties

The tax rates for ordinary income vary depending on whether you’re single or married, how much money you earn annually and which income tax bracket applies to you.

Capital Gains Vs. Ordinary Income Taxes: What’s The Difference?

A handy way to think about capital gains versus income tax is to picture income tax as a mandatory fee the federal government charges on the money you earn from a job or through personal effort (such as a side gig or passive income). Capital gains taxes are charged on the profit you earn from selling an asset – like a vacation home or stocks.

Let’s review the major differences of each type of tax.

How Capital Gains Are Taxed

The rate of capital gains taxes is adjusted each year to keep pace with inflation. For 2023, the capital gains tax rates are capped at 15% for most individuals. Currently, capital gains tax rates are 0% if you earn below $41,675 per year, 15% between $41,675 and $459,759, and 20% thereafter for single taxpayers and 20% if you’re a married couple filing jointly and earning over $498,500.

Capital gains taxes fall into two buckets: long-term and short-term capital gains. Long-term capital gains are taxed at a more favorable rate and charged on assets sold after holding them for at least a year or more. Short-term capital gains are charged the ordinary income tax rate, which is higher.

As you might imagine, investors are incentivized to buy and hold investments for the long term to save on taxes. However, paying short-term capital gains taxes isn’t uncommon if you day trade stocks, renovate and flip houses or engage in other quick turnaround projects.

How Ordinary Income Is Taxed

First, let’s revisit the concept of short-term gains. Short-term capital gains are taxed as ordinary income, which is higher than long-term capital gains tax rates. If you sell an asset 1 year after purchasing it, you will pay the lower long-term capital gains tax rate instead. The rate you’re taxed on ordinary income depends on your tax bracket.

Capital Gains Vs. Ordinary Income In Real Estate

Real estate is considered a capital asset. And, according to the IRS, individuals are exempt from taxes on the first $250,000 of profit they make from the sale of their primary residence. Married couples are exempt from taxes on the first $500,000. In other words, the federal government is providing a tax break to buyers who invest in real estate.

If you sell your property before owning and living in it as your primary residence for at least 2 years out of the 5 years leading up to the sale, you’ll pay two taxes on the profit from the sale: long-term capital gains taxes on the entire profit from the sale and ordinary income taxes on any profit you realized from the sale of the home in the first year.

Capital Gains Taxes Vs. Ordinary Income Taxes: How They’re Calculated

Here are two examples to help visualize how capital gains and ordinary income taxes are calculated.

How Capital Gains Taxes Are Calculated

Let’s say Alex buys stock for $5,000 and, a year and a half later, they sell it for $7,500. Alex made a profit of $2,500. And because they held the stock for over a year, their earnings will be taxed at the more favorable long-term capital gains tax rate. Because Alex made less than $80,000 in profit, their capital gains tax rate is 15%.

If Alex sold the stock less than a year after buying it, they would have been taxed at their ordinary income rate. This means the amount gets folded into their income taxes.

Continue reading to see how the math works out.

How Ordinary Gains Taxes Are Calculated

Let’s say Alex’s total income is $50,000. According to the IRS, portions of their income would be taxed at 10%, 12% and 22%, respectively.

If Alex sold their stock in less than a year, they would pay 22% (the tax bracket their income falls under) in ordinary gains taxes on the $2,500 they made in profit. However, if Alex reaches the income limit for their current tax bracket, the remaining profit will fall into a higher tax bracket and a higher tax rate will apply.

What Are Capital Losses?

Real estate investors often use capital losses to offset large capital gains in the same tax year. There are circumstances when it may make sense to sell an asset early if it proves disappointing.

Note that capital losses that exceed capital gains can reduce ordinary income. If you want to learn more about how capital losses can create tax advantages, consult a qualified tax professional.

Why Do Tax Planners Love Capital Gains and Losses?

Tax planners can balance income and losses to reduce a taxpayer’s overall tax burden. Tax planners favor capital losses because they can use them to reduce capital gains taxes. Long-term capital gains and losses are important tools in the tax toolbox. Ironically, depending on how you time them out, losses can often be as valuable as gains. For more information, please contact a tax professional.

Capital Gains Vs. Income Tax FAQs

How do I file my capital gains with the IRS?

File IRS form 8949 (Sales and Other Dispositions of Capital Assets) to report your capital gains to the IRS. The gain or loss is also reported on your Schedule D (Form 1040).

Do I pay capital gains first or ordinary income?

Ordinary income is taxed first. Long-term capital gains and dividends are taxed second. Because ordinary income is typically taxed at a higher rate than capital gains, capital gains can’t push you into a higher tax bracket. However, your ordinary income may push your capital gains taxes into a higher tax bracket.

What excludes you from paying capital gains tax?

If your filing status is single, you’re eligible for the capital gains tax exclusion on the first $250,000 in profit if you lived in your home for at least 2 years out of the last 5 years leading up to the sale. Married couples are exempt from the first $500,000 in profit. Selling before satisfying the 2-out-of-5-year rule may lead to tax penalties.

The Bottom Line: Capital Gains May Reduce Your Tax Liabilities

The difference between capital gains taxes and ordinary income taxes is straightforward. Short-term capital gains are taxed at the same rate as ordinary income tax rates. And long-term capital gains are taxed at a lower rate.

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