Income you earn can be taxed as either ordinary income or capital gains. Ordinary income is income you earn from your business or job. Most people declare ordinary income on their taxes. The tax treatment of ordinary income is less favorable than capital gains.
On the other hand when you sell a capital asset, that asset is subject to capital gains tax. You receive capital gains from the sale of certain business assets, stocks, personal assets like your home, etc. Any gains you receive when you sell capital gain assets are taxed at the favorable capital gains tax rate.
How to determine your gain
Most capital assets are purchased at a cost. Any amounts you pay in exchange of the asset or to substantially improve the asset is called the basis of the asset. For example, Sally buys her house for $100,000 and makes $10,000 improvements, the basis of Sally’s home will be $110,000.
The gain is the difference between what you sold the asset for and what you paid for it. If you paid more than you sold it for, then you have a loss. The good news is you do not pay taxes on all the money you collect, just the gain.
Tax treatments of capital gains
Capital gain treatment varies by the type of assets, the length of ownership, and your income tax bracket. For example, a single person who makes less than $36, 900 will be taxed at the 10% or 15% rate. The capital gain tax rate for this tax bracket is 0%. If that same single person earns more than $36,900, they will be in the 25% and greater tax rate and will be taxed at the 15% rate. This is a very simple illustration and the rule surrounding the computation of capital gains tax can be quite complex
Furthermore, long term capital gains (gains from assets you hold greater than 12 months) have the most favorable tax treatment. This is because the government will like to see people make long term investments.
Tax planning implication
If you are going to sell a business or personal asset, you will be better off doing it in periods where you are in a lower tax bracket. Of course, contact your CPA for more applicable advice.