Capital Gains Tax vs. Ordinary Income Tax: Your Guide

Last updated 5 months ago. Our resources are updated regularly but please keep in mind that links, programs, policies, and contact information do change.

When you earn money in America, how it gets taxed depends entirely on where it comes from. The tax system treats your paycheck very differently from profits you make selling stocks or real estate. Understanding this difference can save you thousands of dollars.

The government divides income into two main categories: ordinary income (wages, salaries, interest) and capital gains (profits from selling assets). Each category has its own tax rates, rules, and strategies.

What Counts as Ordinary Income

Beyond Your Paycheck

Ordinary income includes far more than just wages and salaries. The IRS defines it as earnings taxed at standard, progressive rates. This broad category captures most of the money flowing into your bank account.

Common sources of ordinary income include:

• Wages, salaries, tips, and bonuses
• Freelance and contract work payments
• Business profits and self-employment income
• Interest from bank accounts and bonds
• Non-qualified dividends
• Rental income from properties you own
• Retirement plan distributions
• Unemployment benefits
• Even gambling winnings and bartering income

The IRS operates on a simple principle: if you receive economic benefit, it’s probably taxable unless a specific law says otherwise. This means you should assume any money or valuable benefit you receive counts as income until proven otherwise.

How Progressive Tax Rates Work

The United States taxes ordinary income using a progressive system with multiple tax brackets. As your income rises, different portions get taxed at increasingly higher rates.

This doesn’t mean all your income gets taxed at your highest bracket rate. Instead, income gets stacked into brackets like building blocks, with each layer taxed at its corresponding rate.

2024 Federal Income Tax Brackets

2025 Federal Income Tax Brackets

The IRS adjusts these brackets annually for inflation to prevent “bracket creep”—where inflation alone pushes you into higher tax brackets without any real increase in purchasing power.

Filing Your Ordinary Income

Most ordinary income gets reported on Form 1040, the main individual tax return. Depending on your situation, you might need additional schedules:

• Schedule 1: Additional income like unemployment compensation or business income
• Schedule 2: Other taxes like self-employment tax
• Schedule 3: Additional credits and payments like education credits

Your employer reports your wages on Form W-2, banks report interest on Form 1099-INT, and other payers use various 1099 forms to report different types of income.

Understanding Capital Assets and Capital Gains

What Qualifies as a Capital Asset

The IRS defines capital assets very broadly. For most people, this includes almost everything you own for personal use or investment.

Capital assets include:

• Your home and other real estate
• Stocks, bonds, and mutual funds
• Personal items like furniture, jewelry, and cars
• Collectibles such as art, coins, and antiques
• Timber on your property

However, certain business-related property doesn’t qualify as capital assets:

• Inventory held for sale to customers
• Business equipment and buildings
• Accounts receivable from your business
• Copyrights you created yourself

The distinction matters because selling capital assets creates capital gains or losses, while selling business property typically generates ordinary income.

Determining Your Basis

Before calculating gain or loss, you need to know your “basis”—essentially your investment in the property for tax purposes.

Cost Basis: For property you buy, basis usually equals what you paid, including purchase costs like sales tax and legal fees.

Adjusted Basis: Your original basis can change over time:

• Increases include capital improvements that add value or extend the property’s life
• Decreases include depreciation deductions you’ve claimed

Special Basis Rules:

• Inherited property: Your basis becomes the property’s fair market value when the original owner died (often called “stepped-up basis”)
• Gifted property: You generally use the donor’s basis for calculating gains, but the lower of the donor’s basis or fair market value for calculating losses

When Gains Become Taxable

You only owe capital gains tax when you actually sell or exchange the asset. This “realization principle” means you can own appreciating assets for years without paying tax on their increased value.

For example, if you buy stock for $10,000 and it grows to $50,000 over five years, you owe no tax during those five years. The tax only applies when you sell the stock and “realize” the gain.

The Critical Holding Period

How long you own an asset before selling determines whether your gain gets favorable tax treatment.

Short-term capital gains: Assets held one year or less get taxed as ordinary income at your regular tax bracket rates.

Long-term capital gains: Assets held more than one year qualify for special, lower tax rates.

Count the holding period starting the day after you acquired the asset through the day you sold it. Holding something for exactly one year still counts as short-term.

Special holding period rules:

• Inherited property automatically qualifies as long-term, regardless of how long you or the deceased actually owned it
• For gifted property, you can include the donor’s holding period with your own

Capital Gains Tax Rates

Short-Term Gains: No Special Treatment

Profits from assets held one year or less get added to your other ordinary income and taxed at the same rates as your salary. There’s no tax advantage to short-term trading.

If you’re in the 22% tax bracket and make a $5,000 short-term capital gain, you’ll pay $1,100 in additional federal tax on that gain.

Long-Term Gains: The Big Tax Break

This is where smart investing pays off. Long-term capital gains get taxed at special rates that are generally much lower than ordinary income rates: 0%, 15%, or 20%.

Your total taxable income determines which rate applies. Higher earners pay higher capital gains rates, but even the top 20% rate is usually less than the top ordinary income rate of 37%.

2024 Long-Term Capital Gains Tax Rates

2025 Long-Term Capital Gains Tax Rates

Special Cases

Qualified Dividends: Certain dividends from U.S. corporations and qualified foreign companies get taxed at the same favorable rates as long-term capital gains instead of ordinary income rates.

To qualify, you must hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Your broker reports qualified dividends separately on Form 1099-DIV.

Collectibles: Long-term gains from selling collectibles like art, antiques, coins, or precious metals face a maximum tax rate of 28%—higher than the standard long-term capital gains rates.

Net Investment Income Tax: High-income taxpayers may owe an additional 3.8% tax on investment income, including capital gains. This applies when your modified adjusted gross income exceeds:

• $250,000 for married filing jointly
• $200,000 for single filers
• $125,000 for married filing separately

Why Different Tax Rates Exist

The Policy Behind Lower Capital Gains Rates

Congress created preferential rates for long-term capital gains to achieve several economic goals:

Encouraging Long-term Investment: Lower taxes on long-term gains incentivize patient capital that supports business growth and innovation rather than short-term speculation.

Promoting Capital Formation: Reduced taxes on investment returns theoretically free up more capital for businesses to expand and create jobs.

Reducing the Lock-in Effect: Without preferential rates, investors might hold appreciated assets too long simply to avoid taxes, leading to inefficient capital allocation.

Offsetting Inflation: Over long periods, some asset appreciation simply reflects inflation rather than real growth. Lower rates partially compensate for this.

The Short-term Penalty

Taxing short-term gains as ordinary income discourages excessive speculation and rapid trading. The one-year holding period creates a clear line between “investment” and “trading” activity.

This approach treats quick profits more like regular business income, which faces higher tax rates under the progressive system.

Handling Capital Losses

Using Losses to Offset Gains

Capital losses can be valuable tax tools. When you sell assets for less than you paid, these losses can offset your capital gains.

The netting process works systematically:

1. Short-term losses first offset short-term gains
2. Long-term losses first offset long-term gains
3. Any net loss in one category can then offset net gains in the other category

Deducting Losses Against Ordinary Income

After offsetting all your capital gains, you can deduct up to $3,000 of remaining net capital losses against your ordinary income each year ($1,500 if married filing separately).

Carrying Over Unused Losses

If your net capital losses exceed the annual $3,000 deduction limit, you can carry the unused portion forward to future years indefinitely. The character of the loss (short-term or long-term) carries forward as well.

Important Limitations

Losses from selling personal-use property (like your home or personal car) generally aren’t deductible, even though gains might be taxable. Only losses from investment property typically qualify for tax benefits.

The wash sale rule prevents you from claiming a loss if you buy the same or substantially identical security within 30 days before or after the sale. This prevents taxpayers from claiming artificial losses while maintaining their investment positions.

Reporting Capital Gains and Losses

Required Forms

Form 1099-B: Brokers send this form reporting your sale proceeds and often the cost basis of securities sold.

Form 8949: You use this detailed form to report each capital asset transaction, showing proceeds, basis, and any adjustments needed to reconcile with broker reports.

Schedule D: This summary form totals your gains and losses from Form 8949 and calculates your net capital gain or loss for the year.

The multi-step reporting process reflects the complexity of capital gains calculations and helps the IRS verify accuracy. While seemingly burdensome, this system was designed to improve compliance and reduce errors.

Smart Tax Planning Strategies

Timing Your Sales

The most fundamental capital gains strategy involves timing. Holding investments just over one year instead of selling early can dramatically reduce your tax bill.

Monitor your holding periods carefully. If you’re approaching the one-year mark on an appreciated asset, waiting a few extra days could save significant taxes.

Consider your income in different years. Realizing long-term gains in lower-income years might allow you to use the 0% capital gains rate.

Tax-Loss Harvesting

This strategy involves selling losing investments to offset gains from winning investments. Key considerations:

• Harvest losses in taxable accounts, not retirement accounts
• Be mindful of the wash sale rule
• Consider the long-term prospects of investments you’re selling
• Remember that up to $3,000 of excess losses can offset ordinary income

Asset Location Strategy

Where you hold investments matters for taxes. Consider placing:

Tax-inefficient investments (like bonds paying regular interest) in tax-deferred accounts like 401(k)s and traditional IRAs.

Tax-efficient investments (like index funds and individual stocks held long-term) in taxable accounts where you can benefit from preferential capital gains rates.

High-growth investments in Roth accounts where all future growth can be withdrawn tax-free in retirement.

Real Estate Considerations

Home Sale Exclusion: You can exclude up to $250,000 of gain ($500,000 if married) from selling your primary residence if you owned and lived in it for at least two of the five years before the sale.

Investment Properties: Rental property sales face capital gains taxes, but you may also owe depreciation recapture tax at a 25% rate on depreciation you previously claimed.

1031 Exchanges: For investment properties, like-kind exchanges allow you to defer capital gains taxes by reinvesting proceeds in similar properties.

Common Misconceptions

Myth vs. Reality

Myth: Capital gains tax is completely separate from income tax. Reality: Capital gains are part of your total income calculation, just taxed at different rates.

Myth: All property sales trigger capital gains tax. Reality: The home sale exclusion can eliminate tax on primary residence sales, and losses on personal-use property aren’t deductible.

Myth: Inherited property is always tax-free. Reality: You get a stepped-up basis when inheriting, but any appreciation after inheritance is taxable when sold.

Myth: Long-term capital gains rates are always lower than ordinary income rates. Reality: For very low-income taxpayers, both might be taxed at similar low rates, though capital gains still benefit from the 0% rate.

Myth: You can deduct unlimited capital losses against ordinary income. Reality: You can only deduct $3,000 per year, though unused losses carry forward indefinitely.

The Bottom Line Comparison

Ordinary Income vs. Capital Gains Tax Comparison

Understanding these differences empowers you to make smarter financial decisions. The tax code rewards patient investors with significantly lower rates on long-term gains while treating short-term trading like regular income.

Key Resources

The IRS provides comprehensive guidance on these topics:

• Publication 17: Your Federal Income Tax (comprehensive individual tax guide)
• Publication 525: Taxable and Nontaxable Income
• Publication 544: Sales and Other Dispositions of Assets
• Publication 550: Investment Income and Expenses
• Publication 551: Basis of Assets

For ongoing tax planning, consider consulting with a qualified tax professional who can help you navigate the complexities and optimize your specific situation.

The distinction between ordinary income and capital gains tax isn’t just academic—it’s one of the most powerful tools in the tax code for building wealth efficiently. By understanding these rules and planning accordingly, you can keep more of your hard-earned money working for you.

Our articles make government information more accessible. Please consult a qualified professional for financial, legal, or health advice specific to your circumstances.