A capital gain occurs when an asset such as a stock or bond increases in value, making it worth more than what the holder initially paid for it. Similarly, a capital loss occurs when an asset decreases in value, making it worth less than its original purchase price.
Capital gains and losses are reported to the IRS on income taxes. However, the IRS does not require filers to report gains or losses until the assets in question are actually sold off. Once an asset is sold at either a profit or a loss, it's considered a realized gain or loss and must be reported accordingly.
Short-Term Capital Gains versus Long-Term Capital Gains
Capital gains are categorized as either long-term or short-term. If an asset is held for more than one year and then sold for a higher price than the original purchase, it's considered a long-term capital gain. An asset held for less than a year and sold at a profit is considered a short-term capital gain.
Each type of capital gain comes with its own tax implications. Short-term capital gains are taxed as ordinary income, whereas long-term capital gains taxes are typically capped at 15% for most taxpayers, which is generally lower than the rate applied to ordinary income. Furthermore, low-income individuals may not be subject to long-term capital gains taxes at all. The long-term versus short-term distinction applies to capital losses as well, but from a tax perspective, there's really no difference in treatment.
Carrying Gains and Losses Forward
If capital losses exceed capital gains, the filer is entitled to claim a deduction against the loss in the amount of $3,000 or the total net loss, whichever is less. When a net capital loss exceeds the $3,000 limit, it can be carried forward to future years.
In the following year, the loss carried forward would first be used to offset potential capital gains. If capital losses still exceed capital gains, the filer can claim up to $3,000 as a loss and continue doing so year over year until the net loss amount is reduced to zero.
Capital gains, however, cannot be carried forward. Once an asset is sold for more than its original purchase price and a gain is realized, the gain must be declared in full on that year's taxes. For this reason, those looking to sell off assets should do so strategically to minimize any potential tax burden that might ensue.