Purchasing assets such as real estate, stocks and mutual funds that have the potential to increase in value over time is a common way to invest and build wealth over time. In personal finance and investing, the terms "equity" and "profit" describe different, yet related concepts associated with the value and growth of investments.
What Is Equity?
In personal finance, equity refers to the value of ownership a person or organization has in an asset. For example, when you buy a home, your home equity is the total value of the home minus any debt you have on the home. Similarly, when you purchase a share of stock in a company, the value of the stock is equity, since stock shares represent small portions of ownership in the companies that issue them.
What Is Profit?
Profit describes the gain you realize when you sell an asset that has increased in value over time. For example, if you buy a home for $200,000 and sell it for $300,000 five years later, your profit is the gain of $100,000. From the perspective of a company, profit is the amount by which total sales or revenue exceeds costs.
How Equity Determines Profit
The current equity value of an asset minus its original equity value equals the amount of any profit or loss you realize if you sell the asset. For instance, if you buy share of stock for $40, your equity at the time of purchase is $40. If the stock's value goes up by $10, you gain $10 worth of equity and can sell the stock to make a profit. However, if the stock's value goes down, you lose equity, and if you sell the stock, you incur a loss equal to the amount of lost equity.
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When you buy assets and sell them for a profit, the profit is also a capital gain. The Internal Revenue Service taxes capital gains on investments. IRS regulations state that gains realized on investments you hold for a year or less are considered short-term capital gains, while investments you hold longer than a year are long-term capital gains. Long-term gains are taxed at a maximum rate of 15 percent in 2011, while short-term gains are taxed at the same rate as income, which can be as high as 35 percent.