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How does this tax penalty operate, and is the rule one year exactly? Clearly, I don't understand this at all. Any help is appreciated!

To qualify for long term capital gain rate a stock has to be owned for more than a year. When the holding period is one year or less, the income is taxed at short term capital gains. Short term capital gains are taxed as regular income.

It isn't a "penalty" such as the federal 10% penalty for early withdrawl from retirement plans, but lack of qualification for a possible lower tax rate. For most, long term capital gains tax rate will result in lower taxes, but it isn't guaranteed. There are situtations, such as those subject to AMT or with captial losses, that may not see any difference in actual taxes.

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