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Understanding Capital Gains Tax

Capital gains are simply the profits earned when a capital asset is sold at a higher price than what it was purchased for. A capital loss occurs when a capital asset is sold at a lower price than what you originally paid. Gains and losses are unrealized -- meaning they're considered "paper" gains or losses -- until the investment is sold, at which point gains and losses are realized. For the purposes of this article, we're talking about realized gains and losses on investments (although other property, like cars and furniture, also counts as capital assets).

Capital gains taxes apply to investments held in taxable accounts -- not to investments held in individual retirement accounts or 401(k)s. The buying and selling that creates capital gains and losses can be done by the fund manager or by the investor holding the fund.

Capital gains are taxed in one of two ways. If you hold an investment for a year or less before selling, any gains will be treated as short-term capital gains. If you hold the investment longer than a year before selling, any gains will be classified as long-term capital gains. All realized capital gains must be reported to the IRS.

Generally, long-term capital gains are taxed at a lower rate than short-term capital gains. You pay your ordinary income tax rate on short-term capital gains, while long-term capital gains are taxed between 0% and 20% based on your tax bracket. Those in the highest tax bracket could be hit with an additional 3.8% Medicare surtax, effectively raising their capital-gains tax rate to 23.8%. Taxpayers in the lowest income brackets often have no tax liability on long-term capital gains, so the length of time you hold your investments can make the difference between paying substantial taxes and paying none at all.

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