An important part of the “fiscal cliff” tax deal passed by Congress in early 2013 was a provision that permanently established a set of tax rates for capital gains. These rates are generally lower than those for ordinary income—in some cases, as low as 0%. So, what exactly is the difference between ordinary income and capital gains? Are capital gains only something rich people have?
What is Ordinary Income?
Ordinary income is what most people think of as income—your salary from a job, interest on savings accounts or bonds, rental income, profits from owning a business, and income from retirement accounts and pensions. Ordinary income that falls within a specified range (adjusted annually) is taxed at the following ordinary income tax rates:
Each tax rate applies to the ordinary income earned within the income range specified for that rate (those amounts are adjusted annually).
What is Capital Gains?
There is another way you can receive income: sell something you own. This can be a house, an old computer, mutual fund shares, stocks, or bonds. These are all capital assets, and any profit you receive from selling them is taxable income. However, this profit is classified as a capital gain, which you pay tax on at capital gains tax rates. The tax rates on profits earned on capital assets owned for more than one year (long-term capital assets) are based on your overall income tax bracket. The long-term capital gains tax rates are as follows:
- 0% if you're in the 10 or 15% marginal income tax bracket
- 15% if you're in the 25%, 28%, 33%, or 35% marginal income tax bracket
- 20% if you're in the 39.6% marginal tax bracket.
Income from the sale of collectibles, gold, silver, and similar items is taxed at 28%.
Of course, wealthy people own capital assets (indeed, they own most of them), but they're not the only ones. Almost everything you own for any purpose, other than business, is a capital asset. This includes both tangible property like your home, and intangible property like stocks and mutual funds. There are two main types of capital assets: personal use property and investment property. personal use property consists of things you use in your daily life such as:
- your main home
- a vacation home or boat
- household furnishings
- a coin or stamp collection
- clothing and jewelry, and
- any vehicle used for pleasure or commuting.
Investment property consists of things like:
- corporate stocks and bonds (including stock in a small company that is not publicly traded)
- mutual funds
- government bonds
- vacant land, and
- partnership and limited liability company ownership interests.
The one significant type of property that’s not a capital asset is business property. This includes:
- inventory or merchandise held mainly for sale to customers (or property that will become part of merchandise)
- equipment and other personal property used by a business—for example, office furniture and computers
- real property used for business or as rental property, and
- the copyright in a literary, musical, or artistic work you create yourself, pay someone to create, or purchase from someone else.
Because business property is not considered a capital asset, different tax rules apply.
Why should income from capital gains get such favorable tax treatment? One reason is to encourage people to invest--a lower tax on capital gains encourages risk-taking and entrepreneurship. Another reason is that the wealthy people who own most capital assets have a lot of influence in Washington, D.C.