Simply put, capital is money. In order to grow that capital, it is invested in various assets such as land, buildings, stock, bonds, commodities such as precious metals, or art. When those assets are sold, if the selling price is higher than the purchase price, then the difference between the two is a "capital gain."
For instance, if you bought a house for $120,000 and sold it some time later for $210,000, then your capital gain was $90,000. Similarly, if you bought 100 shares of stock at $20 each (total investment is $2,000) and sold all the shares some time later for $32 each (proceeds of $3,200), then you have a capital gain of $3,200 - $2,000 = $1,200.
Of course, you could sell the asset for less than you paid, in which case you suffer a capital loss.
Short term vs long term
How long you hold the investment between purchase and sale determines the whether the capital gain is considered short term or long term. If the holding period is one year or less, then it is considered short term. If it is more than one year (a year plus a day, minimum), then it is long term. In the United States, the tax owed (if any, depending on the investment account type) on the gain is different for each holding period.
Calculating the capital gain
The cost to obtain the asset and the cost to dispose of it are also included in the calculation, unlike the simple examples given above. So, let's expand on that a bit.
For a house, the costs such as the real estate agent's commission, are added to the purchase price (if the buyer is paying that commission). If, for the house above, this was $3,000, then the actual cost is $123,000. If the commission upon sale is $4,500, then the net proceeds is $210,000 - $4,500 = $205,500. Then capital gain would actually be $205,500 - $123,000 = $82,500.
Similarly, when buying or selling stock, the commission paid to the broker is either added to the cost or subtracted from the proceeds. If the commission was $10 each way in the above example, the cost would actually be $2,010 and the net proceeds would be $3,190, resulting in a capital gain of $3,190 - $2,010 = $1,180, instead of $1,200.
Note, though, that cash dividends received do not reduce the original cost of the stock, even if those are reinvested in more shares of the company. Stock dividends and stock splits do, however. For more reading on this, please visit the IRS website.
Capital gains and mutual funds
At the end of the year when you receive your statement from any mutual funds you might own, you may notice "capital gain distributions." These are your share of the short- and long-term capital gains the mutual fund realized during the year from selling the various stocks held by the fund. Unlike a corporation, a mutual fund does not pay income taxes on those gains. Instead, the fund distributes that year's net investment income (the total of dividends and interest received, less fund expenses) and net realized gain (gains less losses on securities sales) to the fund's shareholders. That means you get to foot the taxes due on those gains.
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