Direct answer: A capital gain is the profit from selling a capital asset for more than its adjusted cost basis. The federal tax rate depends entirely on how long you held the asset: gains on assets held one year or less are taxed as ordinary income at rates up to 37%, while gains on assets held more than one year qualify for preferential long-term rates of 0%, 15%, or 20% depending on taxable income. That rate difference is one of the most actionable tax decisions in investing.
Capital Gains Tax: What It Is and Why Investors Care
What Is a Capital Gain?
A capital gain is the profit realized when you sell a capital asset for more than your adjusted cost basis in that asset. Capital assets include stocks, bonds, mutual funds, ETFs, real estate, collectibles, and most other investment property. The gain is "realized" only when you actually sell; an asset that has risen in value but remains unsold produces an unrealized gain that is not yet taxable.
The adjusted cost basis is your starting point for calculating any gain or loss. It begins with the purchase price plus any commissions or transaction fees paid at purchase. The basis is then adjusted upward for reinvested dividends (in the case of mutual funds or DRIPs), stock splits that required a cash outlay, and improvements to real property. It is adjusted downward for return-of-capital distributions and depreciation deductions on business property.
When you sell, the formula is simple: sale proceeds minus adjusted cost basis equals your capital gain (or loss if negative). That gain is then classified as short-term or long-term depending on how long you held the asset, which determines the applicable tax rate.
Realized vs. Unrealized Gains
An unrealized gain has no tax consequence. You owe no tax on appreciation until you actually sell the asset. This is one of the most valuable features of long-term investing: you can defer taxation indefinitely simply by holding, allowing the full pre-tax value of the investment to compound. Warren Buffett has cited this deferral benefit explicitly as one of the reasons he prefers to hold rather than trade appreciated positions.
The flip side is that an unrealized gain creates an embedded tax liability. If you need to sell the position, a portion of the proceeds belongs to the government. Planning around that embedded liability, for example by holding until death to trigger the step-up rule, or by donating appreciated shares directly to charity, is a core element of tax-efficient investing.
Short-Term vs. Long-Term Capital Gains
The single most important factor in capital gains taxation is the holding period. The IRS divides gains into two categories based on whether you held the asset for more than one year.
Short-Term Capital Gains
A gain is short-term when you hold the asset for 365 days or fewer. The holding period begins the day after the trade date of purchase and ends on the trade date of sale. If you buy on January 1, the holding period begins January 2. You must hold through at least January 2 of the following year (366 days total) to qualify for long-term treatment.
Short-term gains are taxed as ordinary income at your marginal federal bracket: 10%, 12%, 22%, 24%, 32%, 35%, or 37%. For a high-income earner, a short-term gain is taxed identically to wages. There is no preferential treatment.
Long-Term Capital Gains
A gain is long-term when you hold the asset for more than 365 days (at least 366 days). Long-term gains qualify for preferential federal rates: 0%, 15%, or 20% based on your total taxable income. For most middle-income investors, the rate is 15%, compared to a short-term rate that may be 22% or 24%. For very high earners, the rate is 20% rather than 37%, a 17 percentage point differential on the same gain.
The practical implication: an investor approaching the one-year mark on a position with a large gain has a powerful financial incentive to hold a few additional weeks or days to cross the threshold, assuming the investment thesis remains intact.
Holding Period Edge Cases
Several situations create non-obvious holding period rules. Gifted securities carry the donor's holding period; if a parent who has held stock for two years gifts it to a child, the child inherits the long-term status. Inherited securities qualify for long-term rates immediately, regardless of how long the heir actually held them. Stock acquired through the exercise of employee stock options begins its holding period on the exercise date, not the grant date.
The 2025 Long-Term Capital Gains Tax Rates
The IRS adjusts the income thresholds for long-term capital gains brackets annually for inflation. For 2025, the brackets are as follows.
| Rate | Single Filers (Taxable Income) | Married Filing Jointly (Taxable Income) |
|---|---|---|
| 0% | Up to $47,025 | Up to $94,050 |
| 15% | $47,026 to $518,900 | $94,051 to $583,750 |
| 20% | Above $518,900 | Above $583,750 |
In addition to the base rates above, high earners face the Net Investment Income Tax (NIIT) of 3.8%. NIIT applies to single filers with modified adjusted gross income above $200,000 and married filing jointly filers above $250,000. This brings the effective maximum federal rate on long-term capital gains to 23.8% (20% plus 3.8%). For short-term gains taxed as ordinary income, high earners face 37% plus 3.8% NIIT, for an effective maximum of 40.8%.
The 0% rate is significant and widely underused. An investor with taxable income below $47,025 (single) or $94,050 (married filing jointly) pays zero federal tax on long-term capital gains. This creates a planning opportunity in low-income years: realizing long-term gains, converting traditional IRA balances to Roth, or rebalancing a taxable portfolio at zero tax cost.
Cost Basis Methods and the Step-Up Rule
When you sell shares that were purchased in multiple lots at different prices, you must choose which lot you are selling. The IRS allows several methods, and the choice can significantly affect your tax bill.
Cost Basis Methods
FIFO (First In, First Out) is the IRS default. The oldest shares are treated as sold first. If your oldest shares have a low basis and a large gain, FIFO can trigger a large taxable gain even when you have newer, higher-basis shares available.
Specific identification allows you to designate exactly which tax lots you are selling. This requires you to identify the specific lot at the time of sale (not after) and receive confirmation from your broker. It is the most flexible method and generally the most tax-efficient, because you can sell the highest-basis shares first to minimize current-year gain recognition.
Average cost is permitted only for mutual fund shares. It calculates a blended average basis across all shares held and uses that average as the basis for any sale. It is simple but eliminates the flexibility of specific identification.
The Estate Step-Up in Basis
When an investor dies holding appreciated capital assets in a taxable account, the heirs who inherit those assets receive a new cost basis equal to the fair market value on the date of death. All the appreciation that occurred during the decedent's lifetime is permanently excluded from capital gains taxation. The heirs can sell immediately at the stepped-up basis and owe zero gain.
This rule applies to assets held in taxable accounts. Assets held in tax-deferred retirement accounts (traditional IRA, 401(k)) do not receive a step-up; withdrawals by heirs are taxed as ordinary income. Roth IRA assets pass to heirs income-tax-free but also do not receive a step-up (the step-up is irrelevant for Roth assets because Roth distributions are already tax-free).
The step-up rule creates a powerful incentive for high-net-worth investors with large embedded gains to hold appreciated taxable assets until death rather than selling during their lifetime. The tradeoff is foregoing the liquidity and the ability to redeploy the capital into other investments.
Frequently Asked Questions
What makes a capital gain short-term versus long-term?
A capital gain is short-term when you sell an asset you held for 365 days or fewer, counting from the day after purchase through the day of sale. It is long-term when you held the asset for more than 365 days, meaning at least 366 days. The distinction matters because short-term gains are taxed at ordinary income rates that can reach 37%, while long-term gains qualify for preferential rates of 0%, 15%, or 20% depending on your total taxable income. A single additional day of holding at the threshold can produce a meaningfully different tax outcome on a large gain.
What are the 2025 long-term capital gains tax rates?
For 2025, the 0% rate applies to single filers with taxable income up to $47,025 and married filing jointly filers up to $94,050. The 15% rate applies to single filers with taxable income from $47,026 to $518,900 and married filing jointly filers up to $583,750. The 20% rate applies above those thresholds. High-income earners may also owe an additional 3.8% Net Investment Income Tax (NIIT), bringing the effective maximum federal rate to 23.8%. These thresholds are adjusted annually for inflation.
How does the step-up in basis affect capital gains tax at death?
When you inherit a capital asset held in a taxable account, your cost basis is stepped up to the fair market value of the asset on the date of the original owner's death. All appreciation that occurred during the decedent's lifetime is permanently excluded from capital gains tax. If you sell the inherited asset immediately after receiving it, you owe zero capital gains tax on that embedded gain, regardless of how large it was. This is one of the most significant estate planning benefits available to investors with large unrealized gains in taxable accounts.