How do capital gains typically affect tax liability?

Capital gains generally affect tax liability by being taxed at lower rates than ordinary income, which is why the correct choice is that they are taxed at lower rates than ordinary income.

The tax code distinguishes between short-term capital gains, which arise from the sale of assets held for one year or less and are taxed at the individual’s ordinary income tax rates, and long-term capital gains, which are gains from the sale of assets held for more than one year. Long-term capital gains benefit from preferential tax rates, which are typically lower than the rates applied to regular income. This incentivizes long-term investments and impacts overall tax liability favorably for individuals making such investments.

In contrast, the other options do not accurately represent the treatment of capital gains. For example, while some gains may qualify for exemptions or deferrals, stating that they are not taxable overlooks the necessary specifics of how these gains fit into the tax framework. Similarly, claiming they are taxed at ordinary income rates ignores the differentiation between short-term and long-term gains. Lastly, stating they increase taxable income but do not affect tax brackets fails to acknowledge that capital gains can indeed bring taxpayers into higher brackets based on overall income.

Understanding how capital gains are taxed can help individuals and tax professionals strategize on