A capital gains tax is a tax levied on the realized gain of an investment. To break it down, a “capital gain” is acquired when an asset is sold for higher than its initial purchase price. On the opposite end of the spectrum, a “capital loss” is acquired when an asset is sold for lower than its initial purchase price.
If you bought a share of Corporation X for $50 and sold it for $60 at a future date, you would have experienced a capital gain of $10. Likewise, if you purchase the same share of Corporation X for $50 and sell it for $40, you would have experienced a capital loss of $10.
A capital gains tax would be levied on the $10 gain in the above example. Note that capital gains are only taxed when the gain is realized. For example, if you bought a share of Corporation X for $50 it increased every year, eventually rising to $100 without selling the share, you would not be liable for capital gains tax on this investment. This example would be know as an unrealized gain of $50 ($50 purchase price + $50 unrealized gain = $100 current share price). If you decide to sell the share of Corporation X at $100 and reap your $50 profit, you would be realizing the gain and capital gains tax would be levied on the $50 gain.
Now, once you are ready to sell an asset, the asset’s realized gain will be taxed according to its length of ownership. A “short term” capital gain is levied on an asset sold after less than one year of ownership; a “long term” capital gain is levied on an asset sold after more than one year of ownership. Short term capital gains tax is taxed at the owner’s standard earned income tax rate, while a long term capital gain is taxed at a lower rate (or even ignored completely depending on the investor’s marginal tax bracket).
The reason behind taxing short term capital gains at a higher rate than long term capital gains is to promote long term investment in the economy. The federal government wants to encourage investors to keep their money in the stock market for longer amounts of time. Therefore, longer term investments are granted lower tax liabilities.