Capital gains arise when the selling price of a property exceeds its original cost basis. The cost basis includes the purchase price and any qualifying expenses, such as closing costs and improvements. The difference between the selling price and the cost basis is the capital gain.

Step 2: Classification of Capital Gains:

Capital gains are categorized as either short-term or long-term, depending on the holding period of the property. If the property is held for one year or less, the gain is considered short-term. If held for more than one year, it is classified as a long-term capital gain.

Step 3: Tax Rates for Capital Gains:

The tax treatment of capital gains varies based on their classification:

Short-term Capital Gains: Taxed at the individual's ordinary income tax rates, which can be higher than rates for long-term gains.

Long-term Capital Gains: Subject to preferential tax rates, generally lower than ordinary income tax rates. The specific rates depend on the taxpayer's income level.

Step 4: Exemptions and Deductions:

Certain exemptions and deductions can reduce the taxable amount of capital gains:

Primary Residence Exclusion: Homeowners may exclude a portion of the capital gain (up to a specified limit) from the sale of their primary residence.

Investment Property Deductions: Expenses related to the sale of investment properties, such as real estate agent fees and closing costs, can be deducted from the capital gain.

Objective Type Question:

What is the key factor in determining whether a capital gain is classified as short-term or long-term?