The difference between capital gains and other types of investment income is the source of the profit.
Capital refers to the initial sum invested.
A capital gain, therefore, is the profit realized when the value of the investment increases.
For example, assume you have purchased 1,000 shares of stock in company A at $10 per share.
The capital expenditure, therefore, is $10 x 1,000, or $10,000.
Now assume the value of each share increases to $20.
If you sell your total income is $20 x 1,000 or $20,000.
The capital gain on this investment is then equal to the total profit minus the initial capital, $20,000 – $10,000 or $10,000.
Investment income that is not attributable to capital gains refers to things such as earned interest or dividends.
Unlike with capital gains, the amount of return for these investments is not reliant on the initial capital expenditure.
In the above example, assume company A pays a dividend of $2 per share.
If dividends are paid prior to the sale of shares, the investment income generated is $2 x 1,000 or $2,000.
Using a different example, a savings account totaling $10,000 with a 2% annual interest rate will generate investment income totaling $10,000 x 2% or $200, in its first year.
Another key difference between capital gains and other types of investment income is the rates at which they are taxed.
Tax rates vary depending on the type of investment, the amount of profit generated and the length of time an investment is held.