Short-term vs. Long-term capital gains rates explained
a.k.a. Making sense of the complicated tax system
What are we talking about?
Today I want to go over the differences in tax rates for short-term vs. long-term Capital Gains.
For those loyal readers out there who saw my earlier post about cost basis, and Zac’s post about owing tax on cryptocurrency, you may be wondering exactly how big of a difference there is in a long-term vs. short-term gain from a tax perspective. This is a complicated questions thanks to Federal, State, and Local taxes all playing a part but don’t worry, we’ll get to the bottom of it!
For those of you who didn’t read those posts, I encourage you to check them out, but I will try to explain everything below in terms that everyone can understand.
Ok, so what are the differences and how much money are we talking about?
First, it’s important to understand what makes a capital gain or loss short or long-term.
Well, this part is easy! In order to receive short-term capital gain or loss treatment the capital asset (your Cryptocurrency) must be purchased and then exchanged or sold for cash or another capital asset within a one year period. For long-term treatment, the capital asset must be held for one year or more before it is sold or exchanged.
Alright, I get the difference, show me the money.
In order to figure out how much money you may be saving with a long-term gain vs. a short-term gain you must first understand the tax rates that would be applied to your gains.
For a shot-term gain, the tax rate that will be applied to the gain is equal to the taxpayers current marginal tax rate. For a long-term gain you would use specially designated long-term capital gain rates based on your tax bracket.
Sound simple? Sound confusing? Either way, let’s break it down together.
Some of you may be asking, what is a “marginal tax rate”? The marginal tax rate is the rate of tax that you would pay on every additional dollar of income you earn.
In the United States, we have a tax bracket system, so you pay different amounts of tax for different levels of income earned. For example, as a “Single” filer in the U.S. you pay 10% in tax on the first $9,325 of income earned, 15% on income earned above $9,325 but below $37,950, and 25% on income earned between $37,950 and $91,900. Full tax table for 2017 here.
Did I lose you? Let’s check out the math and see effective vs. marginal tax rate.
Example: You are a single person living in the U.S. who earned $85,000 of gross income in 2017. How would we calculate your tax? First, you take out any applicable deductions or exemptions, for 2017 the allowable personal exemption is $4,050, and the standard deduction for a single filer is $6,350. Then you calculate your taxes based on that number (total income minus deductions minus exemptions). This is known as Adjusted Gross Income (AGI).
So in our example we take $85,000 - $4,050 - $6,350 to show AGI of $74,600. Cool, we just did step 1!
Ok, some of you may be thinking that you would take this $74,600 and multiply it by the 25% from above because this person earned income between $37,950 and $91,900. This is not the case!
You would actually calculate this person’s tax as follows:
First, pay tax of 10% of their income up to $9,350, so they would pay $935 in tax from the first bracket.
Then 15% from the next bracket, this would be $37,950 (top of bracket) less $9,325 (bottom of bracket) multiplied by 15%. So they’d pay $28,625 * 15% or $4,293.75 from the second bracket.
Lastly, they would pay the remainder of their income over the third bracket threshold of $37,950. This would be $74,600 less $37,950, or $36,650 multiplied by the rate of 25% for a total third tax bracket payment amount of $9,162.5. This brings the total Federal tax liability to $14,391.25 ($935 + $4,293.75 + $9,162.5).
Great, we figured out their tax but what’s the difference between marginal and effective rates?
Well the marginal rate would be 25% because for each extra dollar of income earned the taxpayer would pay 25% tax because that is their highest applicable bracket. If the taxpayer earned so much income they went above $91,900 into the next bracket their marginal tax rate would increase to the next bracket rate of 28% and so on.
The 25% marginal rate is important because this is the rate for short-term gains. For example, if our taxpayer above had a $1,000 short-term gain they would pay 25% in Federal tax on that gain or $250, keeping $750 of their gain after-tax. That’s a lot of tax!
On the other hand, the effective tax rate is the actual percent of tax paid. To calculate effective tax rates you divide your tax liability ($14,391.25) by gross income ($85,000). This would be equal to 16.93%. It is important to note, this is just a way for people to understand their tax. You don’t actually pay tax at your effective rate, you use the bracket rates. Basically, what the 16.93% says is that after deductions, exemptions, and taxation the taxpayer got to keep about 83% of their earnings in 2017. Not bad!
Ok, you’ve been good so I’ll share something cool. In 2017 you would owe $0 in Federal Tax if you earned less than or equal to $10,400. Don’t get too excited though, you still may owe State and Local Taxes!
Great, I understand marginal tax rate and how you use that for short-term gains, but what about the long-term rates?
While short-term gains are taxed at taxpayer’s marginal rate (25% from above), long-term gains have their own rate tables.
In 2017, if a taxpayer has a marginal rate of 10% or 15% (the two lowest brackets) they would pay a long-term capital gains rate of 0%! That’s right, 0%!! If a taxpayer has a marginal rate of 15% to 35% (the next four brackets), they would pay a long-term rate of 15%. Lastly, for those wealthiest Bitcoin millionaires among us in the 39.6% bracket (the top Federal bracket), you would pay a long-term rate of 20%.
So, let’s finish our example above to show what the taxpayer would pay short-term vs. long-term.
Example continued: Ok, so we already said the taxpayer would pay 25% of the $1,000 in hypothetical gain if it was a short-term gain meaning they owe Uncle Sam $250! If the taxpayer held the crypto for at least one year that 25% drops to 15% so they would only owe $150 in tax, that’s $100 (10%) in tax savings just for hodling! That’s awesome!
Well, not so fast, don’t forget about State and Local Tax…
For simplicity sake, everything we looked at so far was just Federal taxation. In reality, many states, cities, and municipalities have their own income taxes that must also be paid.
Let’s look at a quick example of someone who is Single and living in New York City.
In our earlier example, we know someone earning $85,000 would be in the 25% Federal tax bracket. So that’s step one. You live in NYC, you earn $85k your marginal rate (same as short-term capital gains rate) is 25% Federally.
BUT living in NYC you also owe New York State and New York City income tax. The New York State marginal tax rate you would owe is 6%, and the New York City marginal rate would be 3.876% (this is based on the state and city tax tables).
So really, if you live in NYC and earn $85k your marginal tax rate would be 25% + 6% + 3.876% or 34.876%!! That’s a lot more than 25%! This would mean on a short-term sell you would only keep about 65% of your gains.
You may now be thinking, well I’m never selling short-term again! But actually, it gets worse (or better if you’re me and you love Tax complexity).
Some States, like New York, also have their own long-term capital gains rates on top of the Federal rate. So you’re not just evaluating 34.786% vs. 15% (the long-term rate we discussed would be applicable to our long-term gain earlier) you’re actually evaluating 34.786% against about 19.41% (15% + New York State Capital Gains rate).
This still makes long-term more advantageous, even with the State long-term rate added. This is because earlier when we looked at just Federal we said the savings would be 10% for a long-term vs. short-term (25% marginal rate vs. 15% long-term capital gains rate). Now, we’re actually saying your marginal rate is 34.786% vs. 19.41% long-term. That’s actually nearly 15% in tax savings by ensuring you hold at least one year!
It’s important to understand that you pay Income Tax not only on a Federal level but on a State and Local level as well. This can add up quickly, especially if you’re self-employed.
It’s also important to understand that taxation can be complicated and that each taxpayer has their own set of facts and circumstances that can impact their tax planning.
That’s why we made TokenTax — TokenTax will automatically figure out the best way to classify your trades as long-term vs. short-term and automatically minimize your Tax Liability. Without TokenTax you may end up paying significantly more on your crypto trading capital gains tax than you would have otherwise.
Check TokenTax out!
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