What Are Capital Gains – Explain Like I’m Five

Written by Olly Milicich in Uncategorized

TL:DR – Capital gains happen when you sell something, like a house or stock, for more than you bought it for. If you keep it for more than a year, you pay less tax. If you sell it in under a year, you pay more tax. You only pay taxes when you actually sell the item.

Definition of Capital Gains

Capital gains happen when something you own, like a collectable, a house, or even a stock, goes up in value, and you sell it for more than you bought it. The difference between what you paid (the cost) and what you sell it for (the price) is your capital gain. It’s the profit you make when selling something.

  • Example: If you buy a comic book for $20 and later sell it for $30, you made a $10 capital gain.

But there’s more to it. Why does the value go up? Well, sometimes the demand for certain things increases, like everyone suddenly wanting that comic you own. Or, the value of things rises naturally over time, like property prices. These shifts are part of the cause and effect of market trends.

Types of Capital Gains

There are two types of capital gains, depending on how long you’ve owned the thing you’re selling:

  • Short-term capital gains: If you sell something you’ve owned for less than a year, any profit you make is called a short-term capital gain. It’s kind of like regular money you make from work, and it usually has a higher tax rate.
  • Long-term capital gains: If you hold onto something for more than a year before selling it, the profit is a long-term capital gain. Long-term gains are taxed at a lower rate to encourage people to keep things longer.

This system is meant to encourage smarter investments. Some people mistakenly believe that selling something quickly always leads to a better deal. But holding onto things longer can give you tax benefits, showing how misunderstandings can affect investor decisions.

Cost Basis

The cost basis is just a fancy way of saying what you originally paid for something. It also includes any extra money you spent on it, like if you fixed up a house before selling it. To figure out your capital gain, you take the price you sold it for and subtract the cost basis.

  • Example: If you bought a bicycle for $100 and later sold it for $150, the cost basis is $100. Your capital gain is $50.

This matters to investors and businesses because knowing your cost basis helps calculate how much profit (and taxes) you’ll have to pay. Even experts sometimes get this wrong, especially if they don’t keep track of fees or repairs.

Realized vs. Unrealized Gains

  • Realized Gains: This is when you actually sell something and make money from it. Once the item is sold, you might have to pay taxes on that gain.
  • Unrealized Gains: This happens when the value of something you own goes up, but you haven’t sold it yet. You don’t pay taxes until you actually sell it.
  • Example: If you have a comic book worth $20 today but the price goes up to $50, you don’t owe taxes until you sell it. Right now, you just have an unrealized gain.

This difference between realized and unrealized gains is key in investment strategies. People sometimes forget they haven’t made any real money until they sell. Holding onto unrealized gains can make investors feel rich on paper, but markets can change fast. For instance, the stock market in 2020 saw huge unrealized gains during the pandemic, but many didn’t cash in at the right time, leading to lost opportunities.

Taxation on Capital Gains

The government takes part of the money you make when you sell something for a profit. But the tax you pay depends on how long you owned the item:

  • Short-term capital gains: These are taxed like your regular income, which means the government could take a bigger chunk.
  • Long-term capital gains: These are taxed at a lower rate to reward you for holding onto things longer.

Also, some special items, like a house or money in a retirement account, have different tax rules. Misconceptions often arise here, with many people believing they’ll be taxed at the same rate for all gains, when in fact tax rates change based on the type of asset and how long it’s been held.

Exemptions and Deductions

Sometimes, you can avoid paying taxes on capital gains. For example, if you sell your home and the profit is less than a certain amount, you might not have to pay any tax at all! These are called exemptions, and they help you keep more of the money you make.

  • Example: If you sell your home and make a small profit, you may not owe taxes on that gain.

These rules can help families and businesses, especially when they’re selling their main house or equipment. However, ethical concerns sometimes arise when wealthy individuals exploit these exemptions unfairly, using loopholes to avoid taxes entirely.

Offsetting Gains with Losses (Tax-Loss Harvesting)

Let’s say you sold one toy and made a profit, but you sold another toy at a loss. You can use that loss to reduce the amount of tax you owe on the gain. This is called tax-loss harvesting.

  • Example: If you make $50 selling a toy but lose $30 selling a different one, you only have to pay tax on $20.

While this sounds like a smart move, it can be tricky. Some investors try to use losses to completely avoid taxes, but the IRS has strict rules on this. Tax-loss harvesting can be a great strategy if used carefully, but some experts have been known to misuse it, leading to audits or penalties.

Impact of Inflation

Inflation means prices go up over time. Sometimes, even if you sell something for more than you paid, the money isn’t worth as much as it used to be because of inflation.

  • Example: You sell a comic book for $10 more than what you paid, but if everything costs more now than when you bought it, that $10 doesn’t buy as much as it used to.

For consumers and businesses, inflation can really change the value of capital gains. Even though you made a profit, rising prices can mean that profit doesn’t stretch as far. For example, during the high inflation periods of 2022, investors had to carefully consider if selling was really as profitable as it seemed.

In Summary:

Capital gains are simply the money you make from selling something for more than what you bought it for. There are different types of gains, depending on how long you’ve owned the item, and you may have to pay taxes on your profit.

For investors, managing capital gains is about timing—knowing when to sell and understanding how taxes and inflation affect your real profit. Experts sometimes misjudge how quickly market conditions or government rules change, which can impact the broader economy. The goal is to invest wisely, stay informed, and plan ahead so that you can make the most of your gains without losing too much to taxes or inflation.

Reference Videos

https://www.youtube.com/watch?v=S3zRtmh5Gn0
https://www.youtube.com/watch?v=a_KXyr3PBto
https://www.youtube.com/watch?v=qq8YndVACV4

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