Capital Gains Tax

Published Jan 25, 2023

Definition of Capital Gains Tax

A capital gains tax is a tax on the profits from the sale of an asset. That means it is a tax on the difference between the purchase price and the sale price of an asset. It is usually imposed on investments such as stocks, bonds, real estate, digital currencies (e.g., Bitcoin and Ethereum) and other capital assets.

The tax rate may vary, depending on how long the asset has been held before the sale. In the United States for example, long-term gains (i.e., from assets held for more than a year) are taxed at a much lower rate than short-term gains (i.e., from assets held for less than a year).

Example

To illustrate this, let’s look at an example. Imagine Joe bought a house for USD 200,000 and sold it two years later for USD 250,000. That means he made a profit of USD 50,000. Now, depending on the jurisdiction, Joe may have to pay a capital gains tax on this profit. For the sake of this example, we’ll assume that the long-term gains tax rate is 10%. That means, Joe has to pay USD 5,000 in taxes on his gains (i.e., 50,000*0.1).

Note that the long-term capital gains tax rate (which applies here because the house was sold after more than one year) is usually lower than the income tax rate. That means Joe would have to pay a lower tax rate on his USD 50,000 profit than he would have to pay on his regular income.

Why Capital Gains Tax Matters

Capital gains taxes are important for governments because they provide a source of revenue. They also help to reduce income inequality by taxing the profits of wealthy individuals and corporations.

In addition, they can be used to discourage certain types of investments, like short-term speculation in the stock market. Finally, capital gains taxes can also be used to encourage long-term investments, as those gains are usually taxed at a lower rate than short-term investments.