Capital gains are the profits realized from the sale of capital assets such as stocks, bonds, and property. The capital gains tax is triggered only when an asset is sold, not while the asset is held by an investor. However, mutual fund investors could be charged capital gains on investments in the fund that are sold by the fund during the year.

There are two types of capital gains: long term and short term; each is subject to different tax rates. Long-term gains are profits on assets held longer than 12 months before they are sold. Long-term capital gains are generally taxed at special capital gains tax rates of 0%, 15%, and 20% depending on your taxable income. Short-term gains (on assets held for 12 months or less) are taxed as ordinary income at the seller's marginal income tax rate.

The taxable amount of each gain is generally determined by a "cost basis" — in other words, the original purchase price adjusted for additional improvements or investments, taxes paid on dividends, certain fees, and any depreciation of the assets. (If you received the property by gift or inheritance, different rules apply to determine your starting basis.) In addition, any capital losses incurred in the current tax year or previous years can be used to offset taxes on current-year capital gains. Losses of up to $3,000 a year may be claimed as a tax deduction.

If you have been purchasing shares in a mutual fund over several years and want to sell some holdings, instruct your financial advisor to sell shares that you purchased for the highest amount of money, because this will reduce your capital gains. Also, be sure to specify which shares you are selling so that you can take advantage of the lower rate on long-term gains. Otherwise, the IRS may assume that you are selling shares you have held for a shorter time and tax you using short-term rates.

Capital gains distributions for the prior year are reported to you by Jan. 31, and any taxes owed on gains must be paid by the due date for your income tax return.

Higher-income taxpayers should be aware that they may be subject to an additional 3.8% Medicare unearned income tax on net investment income (unearned income includes capital gains) if their adjusted gross income exceeds $200,000 (single filers) or $250,000 (married joint filers).

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