Investors receive two types of income: ordinary income and capital gains. Ordinary income includes dividends and interest. Capital gains (or capital losses) are when you sell capital assets for a profit (or loss). Assets can include stocks, bonds, and real estate. Capital gains are better than ordinary income because:

You can control the timing: You don’t have to pay taxes on your gains until you sell the asset. This delay lets you control the timing of your gain or loss so that you can maximize your after-tax profits.

Long-term gains get special treatment: Long-term capital gains (from investments held over a year) are taxed at a lower rate than ordinary income. (Short-term capital gains, on the other hand, are taxed at the same rate as ordinary income.)

Special rates for long-term capital gains In May 2003, new tax laws gave investors a break by lessening the tax liability of dividends and capital gains. For investors holding assets for more than a year, the gain on the sale is taxed at a lower rate than regular income. For investors who are in the top four tax brackets, the long-term rate is 15 percent. Lower-income investors pay capital gains of 5 percent. Dividends and interest, in most cases, are taxed at the same rate as short-term capital gains. The investment tax changes are effective for tax years 2003 through 2008. In 2008, the 5 percent rate drops to zero. On January 1, 2009 the previous capital gain rates are scheduled to return.

Measuring capital gains A capital gain is the difference between the amount realized in the sale and your basis in the asset you sold. Your basis is based on your cost (usually the purchase price plus the brokerage commission) but can be adjusted as a result of different events. For example, if your stock splits while you own it, the basis splits, too. (Most brokerage statements and online portfolio tracking programs can take care of the math for you.) Example: You buy 100 shares of ABC at $35, paying $3,500 plus a brokerage commission of $15. Your basis is $3,515. Later, you sell when the stock is at $39. You receive $3,900 minus a brokerage commission of $15, so your amount realized is $3,885. Your capital gain is $3,885 minus $3,515, or $370. Note: If your basis is greater than the amount realized, you have a capital loss.

What about capital losses? Uncle Sam gives investors a break by allowing them to deduct up to $3,000 in net capital losses each year using the Form 1040 Schedule D. (If married and filing separately, the deduction limit is $1,500.) This tax break can be used to counterbalance capital gains. If you have no capital gains (or if the capital losses are larger than the capital gains), you can deduct the capital loss against your other income. If you lose more than $3,000 in any one year, you can carry over your losses into the next year.

Net short-term loss, no long-term action: You can deduct up to $3,000 of the loss against ordinary income. If the loss exceeds $3,000, you can carry over the excess to the next year. Note: The carry-over is still considered a short-term loss.

No short-term action, long-term loss: You can deduct up to $3,000 of the loss against ordinary income. If the loss exceeds $3,000, you can carry over the excess to the next year. Note: The carryover is considered a long-term loss.

Net short-term loss, net long-term loss: You can deduct up to $3,000 of the loss against ordinary income. The $3,000 deduction is applied against your net short-term losses first. If you have an unused deduction amount, the deduction carries over to the next year as a short-term loss. Any unused long-term loss carries over to next year as a long-term loss.

Net short-term loss, net long-term gain: If the long-term gain exceeds the short-term loss, then the gain is considered a long-term gain and taxed at a favorable rate. For example, if you had a net short-term loss of $2,000 and a net long-term gain of $2,200, you would pay the long-term capital gains tax rate on $200. On the other hand, if the short-term loss exceeds the net long-term gain, the overall loss is considered short-term. This allows you to deduct up to $3,000 against other income and to carry over the excess to the next year.

Net short-term gain, net long-term loss: If the short-term gain is greater than the long-term loss, the net gains is considered a short-term gain and taxed at your ordinary income rate. If the net long-term loss is greater than the short-term gain, the loss is considered long-term, and you’re allowed to deduct up to $3,000 against other income and to carry over any excess to the next year. The best time to take a capital loss is in a year with short-term capital gains or no gains. This timing saves you having to pay taxes at your full ordinary rate.