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Stocks and mutual funds can generate profits or losses for investors. Profits can be taxed at lower tax rates than ordinary income, and losses can offset profits or generate a deduction against your income. Here’s some tips for understanding how capital gains work.A capital gain is the difference between what you paid for an investment and what you received when you sold that investment. If you made a profit on the investment, then you have a capital gain. If you lost money on the investment, then you have a capital loss.

Profits and losses are treated differently depending on how long you have owned the underlying investment. In tax jargon, this is called the holding period. If you have owned the investment for one year or less, the gain or loss is considered short-term. Short-term gains are taxed at your marginal tax rate. If you have owned the investment for more than one year, then you have a long-term gain. Long term profits are taxed at a special capital gains tax rate of 5% or 15%.

The key to calculating your profits and losses correctly is knowing your cost basis, which is the price you paid for the investment, plus any adjustments. For investments, cost basis includes the money you invested, plus commissions you paid when you bought and sold the investment. Keeping track of your cost basis in a mutual fund can be especially tricky, as there are four different ways to calculate your profits. You should consider using a simple spreadsheet for keeping track of your cost basis, such as this sample worksheet, to help make things easier at tax time.

Investors should pay close attention to their losses. Losses first offset gains before the tax is calculated. You will pay tax based on your net gain. Short-term losses will offset short-term gains, and similarly long-term losses will offset long-term gains. If you lost more money than earned in profits, you will have a net capital loss. Capital losses will offset your other income, but you can deduct only $3,000 of net capital losses per year. Any unused capital losses carryover to the following year. One final note about losses: be sure to avoid buying back the same investment that you sold at a loss within 30 days. Doing so will cause your loss to be deferred under the wash sale rule.

More about investing:

• Capital gains and taxes
• Defensive investing: Building a portfolio for volatile markets
• Finding the right ratio of stocks to bonds in your portfolio
• Are recessions good for the economy?
• Understanding bear markets