Special Five-Year Holding Period Rules for Capital Gains

Capital gains tax rates largely depend on how long you hold your investment. Capital gains tax is imposed on all investments that are sold without any other special tax privileges, such as government tax shelters (for example, individual retirement accounts or 401[k] accounts). There is generally no way to avoid capital gains tax, but the Internal Revenue Service applies a lower tax rate than the short-term rates it normally charges to capital investments if you hold your investment for more than 5 years.

The benefit of holding your investments for longer than 5 years is that you take advantage of lower tax rates. If you hold your investment for less than 1 year, for example, you will be taxed at ordinary income tax rates up to 35 percent. If you hold your investment for at least 5 years, you will receive a special tax rate. Your maximum tax rate will be either 18 percent if your ordinary tax rate is more than 15 percent, or 8 percent tax rate if your ordinary tax rate is less than 15 percent. This is supposed to encourage long-term investing.

The drawback to the 5-year rule is that you cannot sell an investment when you might need to. This may create a liquidity problem. For example, if you need money prior to the 5-year period, you may pay higher taxes than if you held the money for more than 5 years. This also may prevent you from buying low and selling high if your stock goes through short-term business cycles that are shorter than 5 years.

Before investing in an investment, consider the stock that you are investing in. To get the benefit of the 5-year holding period rule, you will need to make sure that if the business goes through business cycles where the company's stock will rise and fall, that these business cycles still allow you to realize a profit over the long term, or that these cycles are longer than 5 years so that you can sell and reinvest in a way that makes sense economically.