How Holding Periods Affect Capital Gains Tax

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 Holding Periods Affect Capital Gains Tax

The total capital gains tax you pay is largely determined by the length of time an investment is held. Uncle Sam prefers rewarding long-term shareholders of American businesses. Although the individual tax rates are apt to change, the holding periods generally are not.

It is absolutely vital that you realize the buy and sell date the government uses to determine the length of time you held the asset is the trade date (the day you ordered your broker to buy or sell the investment), not the settlement date (the day when the certificates changed hands).

Assets Held Less Than One Year

Appreciated assets sold for a gain after being held for less than a year receive the least favorable capital gains tax treatment. Generally, the gain will be taxed at your personal income rate (which includes your earned income plus capital gains).

In some cases, the capital gains tax can reach almost twice as high as those levied on long-term investments.

Assets Held More Than One Year but Less Than Five Years

The Internal Revenue Service considers assets held longer than one year to be long-term investments. In May of 2003, Congress lowered the capital gains tax rate to 15% for those in the higher rates and 5% for those in lower income tax brackets.

Originally, there was a sunset provision for these capital gains tax rates to expire at the end of the fiscal year 2008. In 2006, Congress passed a two-year extension through the fiscal year 2010 to keep these favorable rates in place.

According to the IRS literature, “The highest tax rate on a net capital gain is generally 15% (or 5%, if it would otherwise be taxed at 15% or less). There are 3 exceptions:”

"The taxable part of a gain from qualified small business stock is taxed at a maximum 28% rate."
"Net capital gain from selling collectibles (such as coins or art) is taxed at a maximum 28% rate."
"The part of any net capital gain from selling Section 1250 real property that is required to be recaptured in excess of straight-line depreciation is taxed at a maximum 25% rate."

Ramifications of Tax Rates on Your Investment Decisions

The tax code clearly gives an advantage to those holding their investments for longer periods of time, making it easier for patient investors to build wealth. All investment performance must be reviewed net of taxes.

The substantial capital gains tax reduction for long-term investments is one of the reasons value investors tend to favor the buy and hold approach. To put things into perspective:

A woman in the 35.0% tax bracket invests $100,000 in a stock and sells it six months later for $160,000 (a 60% return). She owes $21,000 in taxes on her $60,000 capital gain, leaving her with a $39,000 profit.

The same woman invests $100,000 in a stock and sells it one year later for $150,000 (a 50% return). She owes capital gains taxes of $7,500, leaving her with a net profit of $42,500.

Despite the fact that her return was 10% lower in the second transaction, she ended up with nearly 9% more money in her pocket. The lesson: Capital gains tax implications should be a serious consideration for almost every investment.

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