Capital gains vs. investment income: how they differ

What are capital gains?

When you sell an asset — like a stock, rental property or your own home — any profits you earn above and beyond the purchase price are called capital gains.

“For example, if you buy a stock at $10 and it increases to $20, you would have a $10 capital gain,” said Aviva Pinto, the managing director for Wealthspire Advisors, an investment advisory firm based in New York City.

Capital gains can be either short- or long-term, depending on how long the asset was held before being sold, says Josh Hile, a certified public accountant and the CEO of Citizen Mint, a platform that connects investors with private market opportunities.

If an asset is held for a year or less before being sold, any profit is considered a short-term capital gain. If an asset is held for more than a year before being sold, any profit is considered a long-term capital gain.

You only realize a capital gain when the asset is sold. Expenses related to the sale are excluded from the sale price when calculating your capital gain. So, if you had $250,000 of capital invested in a rental property, sold it for $450,000 and netted $405,000 after paying closing costs, your capital gain would be $155,000 ($405,000 minus $250,000).

» MORE: What is a good investment?

How capital gains are taxed

Capital gains are taxed differently depending on:

• How long you’ve owned the asset
• Your tax filing status
• Your annual income

Short-term capital gains are taxed at your top marginal tax rate, which can be as high as 37%, depending on your annual income. It’s unlikely that you’ll pay a long-term capital gain tax rate higher than 15%. But you might pay a rate as high as 20% to 28%, depending on your income and the type of asset you sell.

For a better understanding of how short- and long-term capital gains are taxed, let’s take a look at an example. Imagine you have a gross annual income of $100,000, file your taxes jointly with your spouse and sell a small residential rental property for a $25,000 capital gain. This was your only asset sale during 2023, and you had no capital losses.

The federal income taxes on your capital gain would vary as follows, depending on how long you held the property prior to its sale.

State taxes and net investment income tax

You may also need to pay state income taxes and net investment income tax (NIIT) on your capital gain.

“For the highest earners, they are charged an additional 3.8% for a net investment income tax,” explained Hile.

State income taxes on capital gains vary depending on the state you live in.

“Some states do not tax capital gains, such as Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas … and Wyoming. Others, such as California, tax capital gains at the same rate as ordinary income,” said Dana Ronald, founder of the Tax Crisis Institute, a tax relief company with offices in Las Vegas and Southern California.

Tax-free capital gains

Some capital gains are tax-free. For example, if you sell your primary residence, you may be able to exclude up to $250,000 of the gain from your income if you’re single and up to $500,000 if you file a joint return with your spouse.

If you sell an asset, it’s a good idea to meet with a tax professional to see if any exclusions apply and to understand what taxes you may need to pay on your gains.

What is investment income?

Investment income is income you earn on an investment you own. Many things can qualify as investments, such as stocks, bonds, real estate, annuities, etc. Some types of investment income you’ll earn from these assets include interest, dividends, rental income and capital gains.

Steven Gilbert, a certified financial planner based in Fort Wayne, Indiana, said: “Broadly speaking, investment income represents any value you receive from the investment you make. Dividends represent payouts of cash or stock that the company makes from its profits. Interest from bonds is the regular coupon payments made for the bond's duration.”

Dividends are traditionally considered either “ordinary” or “qualified.”

• Ordinary dividends are regular distributions of earnings paid by certain corporations and mutual funds to their shareholders. They are taxed at standard federal income tax rates.
• Qualified dividends are subject to the same tax rates as long-term capital gains. To be considered qualified, the dividends must be paid by a U.S. corporation or a qualifying foreign corporation. Plus, the investor must hold the shares for a certain period of time, among other requirements.

» MORE: How often do Treasury bonds pay interest?

How investment income is taxed

Different types of investment income are taxed in different ways.

• Short-term capital gains, interest income, rental income and ordinary dividends are usually taxed at standard federal income tax rates.
• You might pay a lower tax rate for long-term capital gains and qualified dividends.
• You might pay no tax on some investment income. For example, “... if you own municipal bonds, the interest received may be tax-free for your state if you own that state's municipal bonds,” said Gilbert.

Additionally, “your own tax situation could result in different taxation,” said Gilbert. “For example, if you are lower income, you may be able to recognize capital gains at a 0% tax rate, whereas if you are very high income, you may have additional taxes like NIIT added on.”

As an example, let’s say the following applies to you:

• You file your federal income taxes jointly with your spouse.
• You make $300,000 in modified adjusted gross income for the year.
• You have a net capital gain of $75,000.
• You have no other investment income.

Your gross income exceeds the $250,000 threshold amount set by the IRS for a married couple filing jointly. You’ll therefore need to pay 3.8% NIIT on the lesser of your investment income ($75,000) or the difference between your gross income ($300,000) and the relevant IRS income threshold ($250,000).

In this circumstance, you would pay 3.8% of $50,000, which amounts to $1,900 in NIIT.

Income earned from interest, rental properties and ordinary dividends are usually taxed at standard federal rates.

“In addition to federal and state taxes, there may be other taxes and fees associated with buying and selling investments. For example, some investments may have transaction fees or sales charges,” noted Nathan Claire, the founder of Buying Jax Homes, a real estate company in Jacksonville, Florida.

“Overall, understanding how capital gains and investment income are taxed can help investors make informed decisions about their investments and plan for their tax liabilities. It's always recommended to consult with a tax professional for personalized advice based on your individual circumstances.”

Bottom line

A capital gain is the profit you earn when you sell an asset, like your home, a stock or a bond, for an amount greater than what you’ve invested in it. Investment income is a broader income category that includes capital gains and other forms of investment income, like interest, dividends and rental income.

Understanding how these different types of investments are taxed can help you make advantageous investment decisions.