Investing can be done in many different ways. For investors, the tax consequences of each investment can be just as important as the question of what to invest in. You can invest in stocks, real estate, cryptocurrency, or other assets, and once you know the basics of the capital gains tax and how it works, you can apply that understanding to any of the above investment categories. Throughout this article, we will discuss the tax consequences of investments in general, and the concepts learned can be applied to your specific situation and investments.
What is a Capital Asset?
A capital asset is any asset owned for investment or personal use. The IRS does not specifically define what a capital asset is, aside from listing what it is not. Generally speaking, everything is a capital asset, aside from inventory or property sold in the ordinary course of business. Common examples are:
Stocks, Bonds, Mutual Funds, ETFs…
Cryptocurrency
Real Estate
Collectibles (artwork, antiques…)
Business Assets
Tax Cost Basis
One of the foundational aspects of investing is knowing what your cost basis is. Your cost basis is the amount of money you spent to purchase the asset, or invest in it. In addition to the purchase price, there are usually also certain transaction costs that can be included and added to your basis. For instance, brokerage commissions/fees, transaction fees, closing costs…are all examples of costs that can be included in your total purchase price or investment amount. In some cases, the transaction costs are small and will not provide significant value, but are nonetheless important to minimize any future tax impact.
When you first acquire an asset, the purchase price is your original cost basis. But as you hold onto an asset for an extended period of time, depending on the asset type, there can be some adjustments to this original cost basis amount. Certain adjustments can either increase or decrease your basis. These include, but are not limited to:
Depreciation Adjustments (decrease)
Capital Improvements (increase)
Return of Capital (decrease)
Carrying Costs (increase)
For most investments, such as stocks or bonds held in a brokerage or retirement account, the basis is calculated and tracked automatically. The custodian of the account will track these things, so there is very minimal work to be done by you. For other investments, such as real estate, the tracking of the basis and the adjustments is up to you. For a personal residence, any improvements made to the home after you purchase it will need to be recorded and tracked for when you eventually sell the property. For cryptocurrency, many brokers (such as Coinbase or Gemini) are starting to track and report your cost basis, but this is a new requirement and for early crypto purchases, this will likely need to be tracked manually.
In the context of equity compensation, there are also certain adjustments that apply that may or may not be tracked by your broker. We have written in the past about each of these (linked below), and it is important to consider these adjustments, as in some cases, they can greatly reduce your tax liability.
There are also different ways to determine the cost basis in assets, depending on how they were acquired. For those assets that were purchased by you, the basis is relatively straightforward as it depends on the amount you paid for it. But for those assets which you did not directly acquire, such as inherited assets or gifts, the basis may not be so easily determined. In general, if you were to inherit an asset, the basis is equal to the fair market value of the asset at the date of the death. But for assets received by gift, the basis is the same as it was in the hands of the original owner (“carryover” basis).
Capital Gain or Loss Amount
The reason the cost basis or adjusted basis is so important for tax purposes, is that is what determines your gain or loss amount. When you sell or otherwise dispose of an asset, you will need to recognize either gain or loss, depending on the difference between the sales price and your adjusted basis. See below for an example.
Capital Gain - If you were to purchase a stock for $1,000 and later sell it for $10,000, you would recognize a capital gain of $9,000. This is your income amount and you would need to pay tax on this amount.
Capital Loss - If you were to instead sell that stock for $100, you would recognize a capital loss of $900. This capital loss would be available to offset other sources of income (subject to limitations which we will discuss later).
That may seem straightforward, but the legwork of this calculation is in the above cost basis discussion. The cost basis determination is crucial for this calculation of gain/loss, and is where people have the most trouble.
Say for instance, you acquired a home for $1M. A year later, you remodeled the home and spent $500k adding a new bedroom/bathroom. A year after that, you convert the home to a rental property and start claiming $55k of depreciation deductions each year. And five years later, you sell the property for $5M. What is your gain amount? The answer to this depends on your adjusted cost basis amount, which in this case is less straightforward and difficult to track. (Answer is $3.775M of gain ($5M - ($1M + $500k - ($55k * 5))).
Tax Holding Period
The next key aspect of how to calculate your tax liability on a capital gain or loss is the holding period of the asset. That is how long you have owned the asset before you sold it. The two options are less than 1 year (short-term) or greater than 1 year (long-term). Again, while this may seem like a simple concept, the big question to ask is when your holding period began. For certain assets, this question is easily answered, however, for others this can be difficult. For most assets, you acquire the property yourself and that is when your holding period begins. For others, it depends on how you received the property. An inherited asset’s holding period begins on the date you receive the inheritance, but it can never be short-term. While property received through a gift receives a tacked holding period (meaning you are deemed to have acquired the property at the time the donor acquired it), for stock acquired through an option exercise, your holding period only begins once you have vested and exercised the option.
Capital Gain Tax Rates
The holding period question, and whether you held an asset for greater than one year is of great importance, since there are different tax rates applied depending on the answer. If an asset is sold before you hold it for more than 1 year, meaning it is a short-term asset, the tax rate applied is the same as ordinary income. If you meet the long-term holding period before you sell your asset, you will receive lower preferential tax rates.
Short-Term Gains - taxed at a max of 37%
Long-Term Gains - taxed at a max of 20%
There are other tax rates that may apply to capital gains, such as the sale of collectibles, which are taxed at 28%. However, we will mainly focus on regular short-term or long-term gains. Also, please note that this is just considering the Federal tax rates. Each state will have different tax rates and may not have preferential rates for long-term held assets. For example, CA does not recognize long-term capital gain rates, and taxes all income equally.
In addition to the above, consideration should also be given to the Net Investment Income Tax (NIIT), which is an additional 3.8% tax on certain investment income. This tax only applies to those who have income greater than $200,000 for single taxpayers or $250,000 for joint taxpayers. If you earn greater than this amount, and have investment income, such as capital gains, your max tax rate could increase to 40.8% or 23.8%, depending on your holding period.
Tax Planning Opportunities
Now that you have a basic understanding of the capital gains tax and how it is calculated, here are some common tax planning opportunities to learn more about.
Tax Loss Harvesting
Although an asset increasing in value while you hold it is a good thing, recognizing a capital gain and paying the associated tax can be difficult, especially since the tax payments largely come out-of-pocket (i.e. there are no withholdings on capital gains). One way to reduce the tax exposure on a capital gain is to time the sale of that asset triggering a gain with the sale of an asset that is in a loss. For example, if you have one appreciated stock position that you paid $5,000 for and is now worth $10,000, you would recognize a gain of $5,000 when you sell. However, if you had a second stock position that you paid $5,000 for but is now worth $1,000, you can sell this stock at the same time as the other appreciated position and only recognize a net capital gain of $1,000 ($5,000 gain less the $4,000 loss).
It is also never ideal to have many losing investments; however, being strategic about when to sell those and recognize a capital loss is important. For tax purposes, even the losing investments can provide benefits. There are certain investment strategies as well that are solely used to capture tax losses for this purpose.
Charitable Contributions
If you have a capital asset that has appreciated significantly, the thought of selling the entire amount and paying tax can be scary. Another idea is to donate the asset to charity or a Donor Advised Fund (DAF). Most capital assets can be donated to charity, but it is most common that publicly traded securities are used for donations. The reason for this is twofold.
First, you receive a charitable deduction on your tax return for the fair market value of the asset donated.
And second, you do not need to recognize the capital gain on the asset when you donate it, like you would if you were to sell it first. There are a few key things to be aware of when donating stock or other assets, which are briefly covered below.
In order to get a deduction equal to the fair market value, the stock will need to be held long-term. If you donate stock that is held short-term, or less than one year, the deduction is limited to the cost basis of the shares.
Charitable contributions can only be deducted if you itemize your deductions. There are also limits to the amount of deduction you can claim. Different limitations apply for cash versus non-cash donations, and based on whom you are donating the shares to (i.e. DAF versus private foundation). And there are new additional limitations starting in 2026, so you will want to consult us or your CPA to confirm you will be able to take advantage of the donation from a tax perspective.
Lastly, if you were to donate other types of assets that were not publicly traded securities, such as cryptocurrency, or private company stock, the IRS has strict rules on receiving an appraisal in certain circumstances. It is important that these are met in order to receive the charitable deduction.
Exercising Stock Options
Another area of planning is surrounding stock based compensation and timing of exercises. When you receive stock options, either Non-qualified Stock Options (NSOs) or Incentive Stock Options (ISOs), you will need to make the decision about when to exercise that option. In some cases, you may have the ability to early exercise the options with an 83(b) election. That decision is one to evaluate with an advisor, but ultimately the reason it is important within the context of capital gains and planning, is that the earlier you exercise your options and receive the shares, the sooner your shares can become long-term held and qualify for preferential tax rates. The longer you wait to exercise, or if your options convert to shares during a liquidity event, you may be stuck with short-term gains, which can result in more taxes being owed.
Capital Gains Tax Summary
In the context of investing, there is hardly anything better than selling an investment at a gain and making a profit. However, if you are not aware of the tax impacts and how to mitigate them, you may be in for a surprise. There are lots of ways to reduce the sting of paying taxes on your investments if you plan early enough and understand how the taxes work. If you have any questions about the tax impacts of your investments, we are happy to help wherever we can.
