What Are Short-Term Capital Gains? Definition, Rates, and Tax Implications

Special Cases for Short-Term Capital Gains

Some assets receive favorable or less favorable short-term capital gain treatment depending on the nature of the asset. These rules have been enacted to provide tax benefits for some taxpayers or produce heavier tax burdens for others.

• Collectibles are usually taxed at a person’s regular income tax rate, despite higher long-term capital gain rates. There are no special short-term capital gains rates for collectibles.
• Qualified small business stock may receive an exemption if the stock was acquired after a specific date and held for at least five years. That company must have never exceeded $50 million of gross assets.
• Home sales may receive favorable capital gain treatment for homeowners who lived in the home for at least two of the five years leading up to the sale. Due to the period length of the exemption requirement, this exemption does not pertain to short-term capital gains.
• Capital gains from real estate investments may include the recapture of depreciation. The recapture amount of depreciation is often taxed at a maximum rate of 25%, with the non-recapture amount taxed at the prevailing capital gains rate.
  

Advantages of Short-Term Capital Gains Taxes

In the next section, we’ll talk about ways to reduce short-term capital gains taxes. However, there are several reasons why short-term capital gains are advantageous to society. For a single taxpayer, short-term capital gains taxes are unfavorable; however, there are several benefits to short-term capital gains taxes:

• Higher Tax Revenue for Government: Short-term capital gains are taxed at ordinary income tax rates, which can be significantly higher than the tax rates applied to long-term capital gains. This higher tax rate means that the government receives a larger share of the profits generated from short-term trading activities.
• Immediate Revenue for Government: Short-term capital gains taxes provide immediate revenue for the government. Since these taxes are triggered when assets are sold within a short period, the government receives tax revenue sooner compared to long-term capital gains, which are taxed when assets are held for a longer period of time.
• Encourages Long-Term Investing: Taxing short-term gains at higher rates may discourage frequent buying and selling of assets. This can lead to more stable markets, as investors may be less likely to chase short-term profits through the quick buying and selling of securities.
• Fairness in Taxation: Some argue that taxing short-term gains at higher rates promotes fairness in the tax system. Short-term traders who engage in frequent buying and selling of assets are more likely to realize gains within a year. Because these individuals have liquid access to more funds, some argue it’s fairer to subject them to higher tax rates on their profits.
• Simplicity: Taxing short-term gains at the same rates as ordinary income simplifies the tax code. Instead of having separate tax rates for short-term and long-term capital gains, individuals only need to consider their ordinary income tax rates when calculating their tax liability on short-term gains. For as complicated as taxes can be, this is one area that is at least somewhat more straightforward.

Strategies to Reduce Capital Gains Taxes

Increase Holding Periods

Hold onto assets for more than a year to take advantage of long-term capital gains tax rates, which are typically lower than short-term rates. Whenever possible, try not to liquidate an asset that has been held for less than a year, as that often maximizes the tax rate paid on that asset.

Leverage Tax-Efficient Accounts

Use tax-advantaged accounts, such as IRAs or 401(k)s, to defer taxes on capital gains until withdrawal. If capital assets are bought, held, or sold in non-efficient accounts, taxes may be immediately due. Instead, these types of retirement accounts may defer when taxes need to be paid or reduce the taxes to be paid.

Leverage Tax Offset Strategies

Taxpayers can offset capital gains with capital losses from selling losing investments. Though there are limits to what can be sold and offset (and limits on what can then be repurchased to avoid a wash sale), taxpayers can maximize the benefits they receive by making the most of their losses. There are limits to carrying losses forward, and there are limits to what losses can be netted against gains.

Donate Wisely

Taxpayers can donate appreciated assets to charity instead of selling and realizing the gains. When assets are donated, the taxpayer is not assessed gains on a transaction; instead, they receive a donation receipt for the fair market value of their donation. The nonprofit also has not assessed any tax penalty due to its tax-exempt status.

Understanding Wash Sales in Short-Term Trades

Investors engaging in short-term trading are at higher risk of being involved in wash sales: transactions in which an individual acquires a substantially identical security within either 30 days before or 30 days after the sale of the declining investment. The IRS disallows any loss to be recognized on the original sale if the individual buys the same stock immediately after selling it. Wash sales are also directly related to short-term capital gains because the potential loss would be added to the new cost basis.

Consider an example where an investor buys one share of stock for $20, sells the share of stock for $18 after one week, then rebuys the share of stock for $19 two weeks later. The original loss of $2 ($20 - $18) would be disallowed by the IRS. Instead, this loss is added to the new cost basis of the stock and means any potential short-term capital gain on the sale of the currently held stock is calculated on the cost basis of $21 ($19 purchase price + $2 disallowed loss).

Example of Short-Term Capital Gains

Let’s consider an example of a taxpayer named Emily who has recently sold some investments. Emily sold stocks she had held for less than a year, resulting in short-term capital gains of $20,000. She also sold some stocks she had held for more than a year, resulting in long-term capital gains of $30,000.

Emily’s short-term capital gains, which derive from assets held for less than a year, are taxed at her ordinary income tax rates. Assuming Emily falls into the 32% tax bracket for ordinary income, her $20,000 in short-term capital gains would incur a tax liability of $6,400 (32% of $20,000).

Conversely, Emily’s long-term capital gains, originating from assets held for more than a year, are taxed at preferential rates. Depending on Emily’s income bracket, the long-term capital gains tax rate could vary. Let’s assume she falls into the 15% tax bracket for long-term capital gains. With $30,000 in long-term capital gains, Emily’s tax liability would amount to $4,500 (15% of $30,000).

It’s also important to note that, as of October 2024, unrealized gains are not taxed at the federal level. This means that, if Emily has $100,000 of investments that have an unrealized gain, there are no associated taxes with these investments.

The Bottom Line

Short-term capital gains occur when assets are held for one year or less and are taxed at ordinary income tax rates, ranging from 10% to 37%. Long-term capital gains are taxed at more favorable rates and apply to assets held for more than one year. To minimize liability, consider holding assets longer to qualify for long-term capital gains tax rates. Exceptions and strategic measures can reduce short-term capital gains taxes, such as leveraging tax-efficient accounts or donating appreciated assets. As tax laws can be complex and fluid, consulting a tax professional is recommended to maximize financial outcomes and comply with tax obligations.

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