Ordinary Income vs Capital Gains

Of the two things in life everyone can count on, taxes can bring to mind the most questions and doubts for many. The primary difference between Ordinary Income and Capital Gains is the method in which each is earned. Tax rates between the two vary greatly, and can be important in determining investing decisions.

Ordinary Income can be simply defined by the income earned from the rendering of services or the sale of produced goods. This category can also include income earned from the interest or dividends of held investments. Rental income from a home, income earned from your employer, and interest borne from a savings account all fall into this category, and all require investment of time or assets to generate income.

Capital Gains is a different category which is income that is earned from the one time sale of an asset or investment, and can carry a huge impact on the profitability of a venture. Very simply, the difference between the sale price of an asset and the purchase price plus any improvements is equal to the total amount of profit subject to capital gains tax. This category is further broken down into long and short term capital gains. Long term capital gains, or assets held for over one year, are subject to a lesser tax rate than short term capital gains from investments held for less than one year. This can make it very important to fully research the time line of investment that you are willing to commit to. For example, in 2003 based off of IRS Tax statistics, the federal capital gains tax on a short term investment was 25%, where the federal capital gains tax on a long term investment was 18%.

As a prime example, let’s say John and Jane each invests in a property in April of 2002. Each spends $100,000 on their property, and each invests $20,000 in improvements. After 11 months, John and Jane each put their property on the market for $170,000, anticipating $50,000 profit from the sale. Jane, knowing about the benefits of long term investment, holds out for the full purchase price of her property until May of 2003, earning the full $50,000 minus the 18% taxes, for a total net profit of $41,000. John, eager to sell and earn the profits from his sale accepts an immediate offer of $168,000 in March. Accepting that he would earn $2000 less than he had anticipated, he approved the offer happy to have eliminated the liability. Paying a 25% tax rate, John’s total net profit was $36,000.

In the game of capital gains, it is obviously extremely important to have a clear perspective and plan in place to ensure that you are making the most of your investment. In the example given, an over-eager John, not understanding the principles in play, was willing to accept a deduction of $2000 off his original estimated profits, but in fact wound up making $5000 less than what he would have earned by waiting only one additional month before closing a sale.