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Capital gain is an
economic concept
economic concept
defined as the
profit Profit may refer to: Business and law * Profit (accounting) Profit, in accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic en ...
earned on the sale of an
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
which has increased in value over the holding period. An asset may include
tangible property In law, tangible property is literally anything that Tangibility, can be touched, and includes both real property and personal property (or moveable property), and stands in distinction to intangible property. In English law and some Commonwealt ...
, a car, a business, or
intangible property Intangible property, also known as incorporeal property, is something that a person A person (plural people or persons) is a being that has certain capacities or attributes such as reason, morality, consciousness or self-consciousness, and bein ...
such as
shares In financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known ...
. A capital gain is only possible when the selling price of the asset is greater than the original purchase price. In the event that the purchase price exceeds the sale price, a capital loss occurs. Capital gains are often subject to
tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law Law is a system A system is a group of Interaction, interacting or interrelated elements that act accord ...
ation, of which rates and exemptions may differ between countries. The history of capital gain originates at the birth of the modern economic system and its evolution has been described as complex and multidimensional by a variety of economic thinkers. The concept of capital gain may be considered comparable with other key economic concepts such as
profit Profit may refer to: Business and law * Profit (accounting) Profit, in accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic en ...
and
rate of return In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in t ...
, however its distinguishing feature is that individuals, not just businesses, can accrue capital gains through everyday
acquisition Acquisition may refer to: * Takeover, the purchase of one company by another * Mergers and acquisitions, transactions in which the ownership of companies or their operating units are transferred or consolidated with other entities * Procurement, fi ...
and disposal of assets.


History

The history of capital gain in human development includes conceptualizations from pre-1865
slave Slavery and enslavement are both the state and the condition of being a slave, who is someone forbidden to quit their service for an enslaver, and who is treated by the enslaver as their property Property is a system of rights that gives ...
capital in the United States, to the development of property rights in France in 1789, and even other developments much earlier. The official beginning of a practical application of capital gain occurred with the development of the Babylonian's financial system circa 2000 B.C. This system introduced treasuries where citizens could deposit silver and gold for safekeeping, and also transact with other members of the economy. As such, this allowed the Babylonians to calculate costs, sale prices and profits, and hence capital gains.


Calculation

Capital gain is generally calculated through taking the sale price of an asset and subtracting its base cost and any incurred expenses. The resulting value will be the capital gain, or capital loss if negative. In reality, many governments provide supplementary methods of calculating capital gains for both individuals and businesses. These methods can provide taxation relief through lowering the calculated capital gain value.


Example: Australian Taxation Office

The
Australian Taxation Office The Australian Taxation Office (ATO) is an Australian statutory agency and the principal revenue collection body for the Australian Government. The ATO has responsibility for administering the Taxation in Australia, Australian federal taxation sys ...
(ATO) lists three methods of calculating capital gain for Australian citizens and businesses, each one designed to lower the final resulting value of the eligible party's gain. The first is the discount method, whereby eligible individuals or super funds may reduce their stated capital gain value by 50% or 33.33% respectively. The second is the indexation method, which allows individuals and firms to apply an index factor to increase the base cost of the asset, thereby decreasing the final capital gain value. The third is the ‘other’ method, and involves use of the general capital gain formula whereby the base costs of the asset are subtracted from its final sale price.


Example: IRS

The
United States Internal Revenue Service The Internal Revenue Service (IRS) is the revenue service A revenue service, revenue agency or taxation authority is a government agency responsible for the intake of government revenue, including taxes and sometimes non-tax revenue. D ...
(IRS) also provides guidelines on calculating capital gains. The IRS defines a capital gain or loss as “the difference between the adjusted basis in the asset and the amount you realized from the sale”."Topic No. 409 Capital Gains And Losses , Internal Revenue Service". 2020. ''Irs.Gov''. https://www.irs.gov/taxtopics/tc409. Capital gains are also further defined as either short term or long term. Short term capital gains occur when you hold the base asset for less than one year, while long term capital gains occur when the asset is held for over one year. Ownership dates are to be counted from the day after the date which the asset was acquired, through to the day which the asset is sold.


Example: CRA

The
Canada Revenue Agency The Canada Revenue Agency (CRA; ) is the revenue service of the Government of Canada. The CRA collects Taxation in Canada, taxes, administers tax law and tax policy, policy, and delivers Welfare, benefit programs and tax credits for the federal gov ...
(CRA) includes several unique guidelines for calculating individual or business capital gain. The CRA states that individuals may exclude from their capital gains calculation the following types of donations: “shares in the capital stock of a mutual fund corporation… prescribed debt obligations that are not linked notes, ecologically sensitive land… (or) a share, debt obligation, or right listed on a designated stock exchange”."Capital Gains – 2019 - Canada.Ca". 2020. ''Canada.Ca''. https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4037/capital-gains.html#P317_34283. Note that for the exclusion to be approved the donation must be to a qualified donee, and also that capital losses arising from such donations are not eligible to be excluded from an individual's reporting. The CRA states that following a capital gain, individuals may be able to either claim a reserve or claim a capital gains deduction. Individuals are eligible to claim a reserve when the capital gain does not occur as one lump-sum payment but rather a series of payments over time. In order to calculate the reserve, Canadian individuals must calculate their capital gain via the regular sale price minus cost price method, and subsequently subtract the amount of approved reserve for the year. A capital gains deduction is the second form of capital gain calculation which the CRA offers. It is “a deduction that you can claim against taxable capital gains you realized from the disposition of certain capital properties”. Only residents from Canada throughout the previous year are eligible to claim the deduction, and only certain capital gains are eligible for the deduction to be applied.


Example: HM Revenue and Customs

The United Kingdom HM Revenue and Customs (HMRC) office lists certain assets which are eligible to be considered as capital gains. These include “most personal possessions worth  £6,000 or more, apart from your car”, property that is not considered your primary dwelling, your main dwelling if it exceeds a certain size or has been used for business, any shares that are not in an individual savings account or personal equity plan, and any business assets."Capital Gains Tax". 2020. ''GOV.UK''. https://www.gov.uk/capital-gains-tax/what-you-pay-it-on. The HMRC also lists certain assets which are exempt from accruing capital gains, including any gains made from individual savings accounts or personal equity plans, “UK government gilts and Premium Bonds”, and any winnings from lottery, betting or pools. The HMRC states that only gains made above an individual's allowance are eligible to be taxed, and no tax is payable for individuals who accrue gains which are under their Capital Gains Tax allowance.Capital Gains Tax". 2020. ''GOV.UK''. https://www.gov.uk/capital-gains-tax/work-out-need-to-pay. In order to calculate an individual's capital gain, the HMRC requires calculation of the gains for each asset in the relevant 12-month period, which are then summed together and finally reduced by the amount of allowable losses deduction. The HMRC also states that when reporting a loss, “the amount is deducted from the gains you made in the same tax year”.


Taxation of gains

There are typically significant differences in the taxation of capital gains earned by individuals and corporations, and the
OECD The Organisation for Economic Co-operation and Development (OECD; french: Organisation de Coopération et de Développement Économiques, OCDE) is an intergovernmental economic organisation with 38 member countries, founded in 1961 to st ...

OECD
recognizes three simple categories of individual capital income which are taxed by its member nations around the world. These include ,
interest income Passive income is income that requires no effort to earn and maintain. It is called progressive passive income when the earner expends little effort to grow the income. Examples of passive income include rental income and any business activities i ...

interest income
, and capital gains realized through property and
shares In financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known ...
.Harding, Michelle. 2013. "Taxation Of Dividend, Interest, And Capital Gain Income". OECD Taxation Working Papers No. 19. OECD Publishing. The OECD average dividend tax rate is 41.8%, whereby dividends are often taxed at both the corporate and individual level and categorized as corporate income first and
personal income In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods an ...

personal income
second. However, certain countries such as Australia, Chile, Mexico, and New Zealand employ imputation tax systems which allow
corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal ...

corporation
s to redeem imputation credits for tax paid at the corporate level, thus reducing their tax burden. The OECD average interest income tax rate is 27%, and almost all OECD countries excluding Chile, Estonia, Israel, and Mexico tax an individual's total nominal interest income.


Eligible assets

Capital gain can only be earned on the profitable sale of assets. A former Chief Accountant of the
Securities Exchange Commission The U.S. Securities and Exchange Commission (SEC) is a large independent agency of the United States federal government that was created following the stock market crash in the 1930s to protect investors and the national banking system. The pr ...
defined an asset as: “
Cash In economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within those societie ...
, contractual claims to cash or services, and items that can be sold separately for cash”. Practical applications of this definition primarily include stocks and real estate.


Stocks

A capital gain may be earned through the sale of financial assets such as
stocks Stocks are feet restraining devices that were used as a form of and . Form and application The stocks, , and pranger each consist of large wooden boards with hinges; however, the stocks are distinguished by their restraint of the feet. The s ...
. When one sells a stock, they would subtract the cost price from the sale price to calculate their capital gain or loss.


The disposition effect

The
disposition effectThe disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value. Hersh Shefrin and Meir Statman identified an ...
is a theory which links
human psychology Psychology is the science of mind and behavior. Psychology includes the study of consciousness, conscious and Unconscious mind, unconscious phenomena, as well as feeling and thought. It is an academic discipline of immense scope. Psychologis ...
to capital gain in stocks and examines how humans make choices under the threat of a potential capital loss. It reveals a pattern of
irrationality Irrationality is cognition Cognition () refers to "the mental action or process of acquiring knowledge and understanding through thought, experience, and the senses". It encompasses many aspects of intellectual functions and processes such as: ...
within human behaviour, in which stocks which have potential to accrue a capital gain are sold too early, while stocks which are clear losers are held on for too long, thus creating greater capital losses than necessary.


Expected capital gain asset pricing model

This asset pricing model details how the expectations of future capital gains in the
stock market A stock market, equity market, or share market is the aggregation of buyers and sellers of stock In finance, stock (also capital stock) consists of all of the shares In financial markets A financial market is a market in whic ...

stock market
are a key driver of actual stock price movements. In general, “asset price boom and bust cycles… are fueled by the belief-updating dynamics of
investor An investor is a person that allocates capital with the expectation of a future financial return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...
s”, and thereby the optimism regarding future capital gains in a particular stock will often be the cause of the eventual increase in the stock's price.


The 'Lock-In Effect'

The lock-in effect proposes that rather than realize capital gains on stocks, investors should instead revert to substitute securities. Provided that “tax-exempt perfect substitute
securities A security is a tradable financial asset A financial asset is a non-physical asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication o ...
exist”, investors should never realize their capital gains on stocks because it is possible to reduce the risk from a large position in a stock by “costlessly short selling a perfect substitute”.


Real estate

A capital gain may be earned through the sale of physical assets such as houses, apartments or land. In most countries however, the sale of a primary dwelling or main residence is exempt from capital gains tax. For example, the Australian Taxation Office offers a full exemption of capital gains tax on the sale of a primary home, provided the individual or couple meets certain eligibility criteria."Your Main Residence". 2020. ''Ato.Gov.Au''. https://www.ato.gov.au/general/capital-gains-tax/your-home-and-other-real-estate/your-main-residence/.


Efficiency in the real estate markets

The interlink between psychology and capital gain is also frequently seen in stocks, a concept which is similarly explored by Dusansky & Koç. Since houses are not only consumption but often investment expenditures for families, expectations of capital gains through investing in the house as an asset rather than a consumption good has a strong influence on actual housing prices and demand. As stated by Dusansky & Koç, “an increase in housing prices increases the demand for owner-occupied housing services. Thus, housing’s role as investment asset with its potential for capital gains dominates its role as consumption good”.


Bonds

A capital gain may be earned through the sale of intangible financial assets such as bonds. The capital gain would be achieved when the selling price of the bond is higher than the cost price, and the capital loss would occur if the selling price of the bond is lower than the cost price.


Exemptions

Some government departments, such as the Australian Taxation Office (ATO) do not classify gains arising from the profitable sale of a bond as a capital gain."You And Your Shares 2020". 2020. ''Ato.Gov.Au''. https://www.ato.gov.au/Forms/You-and-your-shares-2020/?page=24). If an individual redeems a bond for more than, or less than, the price they paid for the bond, the ATO states that this profit is “not treated as a capital gain” and that the profit should simply be included in the individual's tax return. Similarly, if an individual sells a bond to another individual for more than, or less than, the price they paid for the bond, the ATO states that “this profit is not treated as a capital gain” and that the profit should simply be included in the individual's tax return. However, the United States Internal Revenue Service (IRS) does consider profits from the redemption or sale of a bond as a capital gain. Bond capital gains are calculated in the same method as other capital gains, whereby “the difference between the adjusted basis in the asset and the amount you realized from the sale is a capital gain or a capital loss”.


See also

*
Capital gains tax A capital gains tax (CGT) is a tax on the profit realized on the sale of a non-inventory asset In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (t ...
*
Cash flow A cash flow is a real or virtual movement of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...
*
Investment Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance Finance is the study of financial institution ...

Investment
*
Passive income Passive income is income that requires minimal labor to earn and maintain. It is called progressive passive income when the earner expends little effort to grow the income. Examples of passive income include rental income Renting, also know ...
*
Property income Property income refers to profit or income received by virtue of owning property. The three forms of property income are rent, received from the ownership of natural resources; interest, received by virtue of owning financial assets; and profit, r ...
*
Profit Profit may refer to: Business and law * Profit (accounting) Profit, in accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic en ...
*
Unearned income Unearned income is a term coined by Henry George Henry George (September 2, 1839 – October 29, 1897) was an American political economist and journalist. His writing was immensely popular in 19th-century America and sparked several reform mov ...


References


Further reading

*{{cite journal , last=Black , first=Stephen , year=2011 , title= A Capital Gains Anomaly: Commissioner v. Banks and the Proceeds from Lawsuits , ssrn=1858776 , journal=St. Mary's Law Journal , volume=43 , pages=113 Accounting terminology Capital gains taxes Corporate finance Fundamental analysis Profit Technical analysis Tax terms