Long-Term Capital Gains

What Are Long-Term Capital Gains?

Long-term capital gains (LTCG) are profits from the sale of capital assets — including stock — that have been held for more than one year. The federal government taxes these gains at preferential rates of 0%, 15%, or 20%, depending on your taxable income. These rates are substantially lower than ordinary income tax rates, which top out at 37% federally. For startup employees, achieving long-term capital gains treatment on stock option gains is one of the most valuable tax planning objectives.

The distinction between ordinary income and long-term capital gains is the primary reason that exercise timing, holding periods, and the choice between ISO qualifying and disqualifying dispositions matter so much.

How Long-Term Capital Gains Work

The Holding Period

To qualify for long-term capital gains rates, you must hold the asset for more than one year — specifically, more than 365 days from the date of acquisition. For stock options, the acquisition date is typically the exercise date (the date you purchased the shares), not the grant date.

For ISOs, there is an additional requirement: to receive long-term capital gains treatment on the full spread, you must also hold the shares for at least two years from the grant date (the qualifying disposition requirement).

2026 Federal LTCG Rates

Net Investment Income Tax (NIIT)

In addition to the base LTCG rates, high-income taxpayers pay a 3.8% Net Investment Income Tax (NIIT) on capital gains if their modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly). This effectively raises the top rate to 23.8%.

State Taxes on Capital Gains

Most states tax capital gains as ordinary income — meaning they do not offer a preferential rate. California taxes capital gains at its full 13.3% rate. New York taxes at up to 10.9% (plus 3.876% for NYC residents). A few states have no income tax (Texas, Florida, Nevada) or special capital gains taxes (Washington's 7% excise tax on gains above $270,000, with a 9.9% surcharge above $1M).

Practical Implications for Startup Employees

The Rate Differential Is Significant

For a high-earning employee in California, the difference between ordinary income rates and LTCG rates can be over 20 percentage points:

• Ordinary income: 37% federal + 13.3% CA + payroll taxes ≈ 53%+
• Long-term capital gains: 20% federal + 3.8% NIIT + 13.3% CA ≈ 37%

On a $500,000 gain, this difference is roughly $80,000 in additional taxes. This is the financial incentive driving ISO holding period strategies.

ISOs and the Qualifying Disposition

The primary path to LTCG treatment on stock option gains is through an ISO qualifying disposition. If you exercise ISOs and hold the shares for at least one year after exercise and two years after grant, the entire gain from exercise price to sale price is taxed at LTCG rates. This avoids the ordinary income treatment that would apply to the spread in a disqualifying disposition.

NSOs and Capital Gains

With NSOs, the spread at exercise is always ordinary income — you cannot avoid this. However, any appreciation after exercise (the difference between the FMV at exercise and the sale price) can qualify for LTCG rates if you hold the shares for more than one year after exercise. This is why some employees exercise NSOs early and hold the shares to convert future gains to long-term.

QSBS and LTCG Exclusion

Under Section 1202 (QSBS), up to $15 million (post-OBBBA) in capital gains from qualifying small business stock may be excludable from federal tax entirely. This exclusion applies on top of the LTCG preference — meaning if your shares qualify, you may owe zero federal tax on a substantial gain.

How It Relates to Exercising Stock Options

Long-term capital gains treatment is the prize at the end of a well-executed exercise strategy. For ISOs, this means exercising and holding through the qualifying disposition period while managing AMT exposure. For NSOs, it means exercising early when the spread is small and holding for over a year to convert future appreciation to long-term gains. In every case, model the tax difference between ordinary income and LTCG treatment to understand the financial stakes of your holding period decisions.