The capital gains tax is an income tax levied on profits from sales of capital assets. However, if you're subject to the capital gains tax, your effective tax rate can be as low as zero or as high as 20 percent. What is the capital gains tax? Which assets are subject to the tax? How is the tax rate calculated? Here's a primer on what the capital gains tax involves.

Capital Gains Tax Definition

Capital gains taxes are assessed on the profits realized when a taxpayer sells capital assets. The important distinction is that these taxes are only levied on the actual profits received, not the increase in value over time. This means that taxpayers only have to deal with capital taxes when they actually sell an asset, not when the asset appreciates.

For example, if you hold shares of stock for years, you hope that they will appreciate in value. If your stock gains value every year, you are not required to pay capital gains tax on the appreciated value. However, if you eventually sell the stock and receive more for it than you originally paid, you will be subject to the capital gains tax on the amount of profit you realized.

What Counts as a Capital Asset?

In general, a capital asset is any asset that is owned and used for personal or investment reasons. In practice, though, the term commonly refers to investment products such as stocks, bonds, and mutual funds. Capital assets may also be collectible items or real estate.

In fact, your personal home is a capital asset, and if you sell it for a profit you could be subject to the capital gains tax. However, the IRS allows homeowners to exclude the first $500,000 of profit from a home sale, which greatly reduces the tax impact of a sale. 

How is Capital Gains Tax Calculated?

The capital gains tax only applies to the net gain from a sale, not the total sale price. In fact, if you sell two items in the same year - one for a profit and one for a loss - you may be able to use your capital loss to offset the amount of profit in the other transaction, which will lower your tax.

The capital gains tax rate is far lower than that used for ordinary income. A person in the top income tax bracket who pays 35 percent in taxes on earned income will only pay a maximum of 20 percent capital gains tax on dividends and interest. If you fall into the 10 or 15 percent income tax bracket, you probably won't have to pay any capital gains tax at all as long you've owned the asset for at least a year.

If you sell a capital asset for a profit, you may have to pay the capital gains tax. To get an idea of how high your tax will be, look at your effective tax bracket for clues. If you need assistance reporting your capital gains or figuring out your tax, consult an experienced income tax professional for help.