Many taxpayers are confused when it comes to the taxation of capital gains, and for good reason! In order to comprehend this concept, you’ll need a general understanding of the following: (a) an asset’s holding period, (b) the “netting” rules, (c) ordinary and preferential tax rate schedules, and (d) the 3.8% Net Investment Income Tax. While this may seem overwhelming, answering the following three questions should clear up much of the confusion:

1. How do the “netting” rules work for short-term and long-term capital gains and losses?
2. How do I determine whether my capital gains will be taxed at 0%, 15%, 20%, or my ordinary income tax rate?
3. Will my capital gains be subject to the 3.8% Net Investment Income Tax (NIIT)?

Let’s consider each question in turn.

How do the “netting” rules work for short-term and long-term capital gains and losses?

First, you’ll need to understand the difference between short-term and long-term gains/losses. The difference depends on the underlying asset’s holding period. If an asset is held for one year or less before it is sold, the resulting gain or loss is short-term. If the asset is held for more than one year before it is sold, the resulting gain or loss is long-term.

At the conclusion of the tax year, short-term gains are netted with short-term losses, and long-term gains are netted with long-term losses. Consider the following example:

Net Short-Term Gain/Loss: $5,000
Net Long-Term Gain/Loss: ($7,000)

The final step is to combine the net short-term gain/loss with the net long-term gain/loss. Continuing with the example above, this would result in a capital loss for the year of $2,000. This $2,000 loss is used to offset the taxpayer’s ordinary income. Keep in mind, the maximum allowable capital loss in any given tax year that may be used to offset ordinary income is $3,000. Any amount of capital loss in excess of $3,000 is carried forward to subsequent tax years indefinitely until the full amount is utilized by the taxpayer.

How do I determine whether my capital gains will be taxed at 0%, 15%, 20%, or my ordinary income tax rate?

Short-term and long-term capital gains are taxed differently. Short-term gains are taxed as ordinary income at rates ranging from 10% to 37%, depending on the taxpayer’s total taxable income.* Long-term capital gains (along with qualified dividends) are taxed at preferential rates, according to the table below.



To determine which rate will apply to your capital gains, follow the steps in the graphic below and consider the following example:

How to determine tax liability 

Remember: Both ordinary income and capital gains tax rate schedules are progressive. Net ordinary income fills up the lower tax brackets, then long-term capital gains and qualified dividends are stacked on top. The initial capital gains tax rate is based on where net ordinary income ends. Long-term capital gains and qualified dividends can advance the capital gains tax rate to the next bracket.

* Ordinary income tax rate schedules and standard deductions can be found in our separate piece, “2023 Quick Tax Facts.”

Example: How to Determine Tax Liability

Luke and Rae’s tax bill, including ordinary income tax and capital gains tax, totals $10,082.50.

Will my capital gains be subject to the 3.8% Net Investment Income Tax (NIIT)?

You will be subject to the NIIT if you have net investment income and have modified adjusted gross income in excess of the applicable threshold ($250,000 for married taxpayers filing jointly and $200,000 for single taxpayers). The 3.8% NIIT will be imposed on the lesser of (a) your net investment income or (b) your excess modified adjusted gross income over the applicable threshold.

Let’s repeat steps one through three to account for a modification to our previous example. We will include an additional fourth step to calculate the NIIT.

 

Example: How to Determine Tax Liability with NIIT

Luke and Rae’s tax bill, including ordinary income tax, capital gains tax, and NIIT, comes out to $101,240.60.

* Ordinary income tax rate schedules and standard deductions can be found in our separate piece, “2023 Quick Tax Facts.”