Investing involves risk. Everyone knows that. However, it’s not just your principal at risk. Any gains or losses that you may incur on an asset could also have serious consequences when it comes to your taxes.
Ownership of capital assets brings a number of implications come tax time. Knowing what they are might have some influence in your investment strategies down the line. Your assets are wide-ranging. They could be a property that you live in or rent out. They also may include the furnishings and fixtures within that property. Additionally, your portfolio of stocks, bonds, funds and various other vehicles can be included.
All of these are going to show some form of loss or gain over time. Capital losses and gains will have an impact on your taxes. This article is going to explore all of the important information. We will help you better understand how and why your taxes can be affected by the assets you currently hold.
Selling any capital asset is viewed as something of value that you purchase. The money you spent to own it is measured against the amount of money you are given when you sell that item. If you sell it for more than you paid, that is a capital gain. The opposite means it is a capital loss. Each one will affect your taxes in specific ways. These are through appropriate deductions and various classifications that may apply.
IRS Guidelines for Capital Gains and Losses
The IRS website defines guidelines as to how gains and losses affect your taxes for the filing year. First and foremost, you are mandated by law to report any and all capital gains on your return. In addition, you may deduct capital losses. However, that only qualifies for losses on investment property.
You may not claim a capital loss on property that you hold for personal use. In other words, selling your house for $300,000 less than what you paid is not a deductible capital loss. Conversely, let’s say you sell a property that you have been renting to tenants for $50,000 less than what you paid for it. Then, that loss will qualify for a deduction under the law.
Short-term and Long-term
All capital gains and losses are defined as either short-term or long-term. The determination is based on the length of time during which you have owned an asset prior to selling it. Anything that has been held for a period of one year or longer before you sell it is considered a long-term loss or gain. Less than one year makes it a short-term loss or gain.
Any filer who has long-term gains that outweigh long-term losses is considered to have a net capital gain. That is to the extent that their net long-term capital gain exceeds a net short-term capital loss if any for the filing year.
Perhaps the capital losses exceed capital gains. Thus, the difference is considered deductible on a tax return. It may be applied to help lower other taxable income. There is a maximum annual limit of $3,000 for single filers and $1,500 for married filing separately.
Maybe a filer experiences a total net capital loss that exceeds the annual limit for capital loss deductions. In that case, the remaining amount may be carried over to the following year. It can be accounted for on your return as if those losses were incurred in that year instead of the one prior.
Applicable Tax Rates
The current IRS tax rates that pertain to net capital gains are usually less than those applied to other income received for the year. For short-term capital gains, the tax rates are equivalent to the rates applied to standard income tax.
Conversely, long-term capital gains tax rates are determined by income. Many taxpayers may be eligible for a tax rate of 0%. Those who are in the 10% and 15% tax brackets won’t pay a tax on their long-term capital gains under the law for 2016. Those filers, who are a part of the highest income tax bracket of 39.6%, face a 20% tax rate on their long-term capital gains.
It’s also possible that certain investors will be expected to pay the net investment income tax. That is an additional 3.8%. It is enforced on the lesser of the following amounts. These are the filer’s net investment income or an excess of their adjusted gross income past the income threshold that applies to their status.
For single/head of household, the number is $200,000. For those who are married filing jointly, it’s $250,000. People who are married but filing separately is $125,000.
Reporting your capital gains and losses is done using Schedule D, Capital Gains and Losses. That information is then added to line 13 on your Form 1040.
Defining a Capital Loss
As we’ve discussed, determining a capital loss or gain is classified by the comparison in value between purchasing that asset and selling it off. In the case of a capital loss, an asset is sold off for a price that is lower than what the owner paid to acquire the asset.
Thus, the owner takes a loss on their capital investment. Simply put, when the sale price is less than the original purchase price, you’ve taken a loss on that asset.
When considering a capital loss for reporting on personal income tax, capital gains are subject to getting offset by any capital losses during the year. A net loss can lower your taxable income dollar-for-dollar. Any net loss that is more than $3,000 may be transferred to the next filing year.
That, in turn, will offset any gains in that following year. It’s for the same purpose of lowering the taxpayer’s taxable income amount. This carry over may be repeated along subsequent years until such time that all capital losses have been counted and applied.
Let’s say you’re having a particularly bad year on the stock market. Your portfolio is underperforming across the board and losing value. Perhaps you’ve finally given up on a certain stock that just hasn’t rallied back around. Therefore, you sell it for less than the price you first bought it. That’s a capital loss.
Don’t forget about any expenses you may incur to sell that stock. Those are added to the amount lost. The important distinction here, however, is that you can’t really claim a loss until after the asset is sold off. An under-performing stock that’s still a part of your portfolio and tormenting you with its lack of progress and growth, may now be a waste of time and money on two counts.
It won’t bounce back and you can’t even claim it as a deductible loss from your taxes. Once you do sell it off, it officially qualifies as a capital loss under the IRS rules. Then, you can apply it as a reduction in your income for tax purposes.
Selling an asset for more than you originally paid yields a capital gain. This is considered income in the eyes of the IRS. Guess what? They’re going to want their fair share just like they would with any other income stream. That portion is called a capital gains tax.
When considering a capital gain for reporting personal income tax, the same rules apply in terms of a realized versus an unrealized gain. That is to say, the gain is not realized and thus inapplicable for taxation until the asset is sold off. This is identical to the way a capital loss is considered under the tax laws.
Just as in the previous example, this time your portfolio is doing incredibly well. Now, those stocks and other investments have a higher value than what you originally paid to own them. The capital gains tax doesn’t take effect once you’ve sold off and accepted payment for those investments.
Just because your stocks have increased in value doesn’t mean you can be taxed on those gains yet. That is because they’re not officially a monetary gain. They’re just worth more until a sale is transacted.
For tax purposes, the rate you could be paying on any investment is decided by how long you’ve held onto an asset. As we’ve discussed, short-term investments are those assets held for a year or less. Long-term investments are those that have been owned for more than a year.
The former are taxed at your standard income tax rates. However, those held longer may come with a tax rate that isn’t much higher than 20%. By this criterion, the tax laws favor long-term investors more than the short-term investor.
The amount you could be paying in capital gains tax can have an effect on your investing strategies. This, in turn, could also have an impact on your taxes. Consider the amount you could be paying on an asset if you held it longer than one year.
As an example, let’s pretend you bought 100 shares of Stock X at $15 per share. Your tax bracket comes with a capital gains tax of 10% on long-term gains. You then sold off those shares at $30 each. This means you spent $1500 and made $3,000. That equals a capital gain of $1,500. With the tax of 10% applied to your capital gain, you are taxed $150 on that money. You are left with $1,350 in profit.
A 10% tax took $150 out of your pocket. Yet, imagine what could have been taken had you only held the stock for seven months and paid the normal income tax rate. For some states in the country, that rate can get up to 30%-40%. Therefore, it makes more fiscal sense to keep your investments for a longer period of time. In doing so, you’ll avoid paying higher taxes on your capital gains.
Keep in mind that various types of capital gains can be taxed at varying rates. Additionally, the type of security and the holding period will have an impact on your investing decisions. That’s because they can determine what tax rate you may be facing on the money you’ve earned.
When it comes to any investment asset there’s always a right time and a wrong time to sell. As we’ve already seen, it can be financially beneficial to hold certain investments for a year or more in. This is in order to take advantage of pertinent tax breaks.
The tax rates that apply to your bracket can affect both gains and losses. Those filers in the 10% and 15% brackets won’t be expected to pay any taxes on capital gains received from selling off assets at a profit.
A wide swath of taxpayers could benefit from paying zero taxes on their capital gains. This specifically favors those filers who have scaled back their employment. It also allows those who have retired altogether.
Plus, it assists younger taxpayers who have just started out in the workforce. They earn a small paycheck in an entry level position. Any of these individuals are earning a return on their investments may find themselves in the enviable position of selling their assets. They need not be concerned with offsetting their gains by selling an investment at a loss.
The Wash-Sale Rule
Any system in place to regulate individuals will often find those same people scheming to work around said system. They do it in order to gain in some fashion. That is especially the case when the imposed regulations are in place expressly to prevent that gain.
Therefore, the tax code and the many loopholes are detected by savvy tax lawyers. In this instance, the IRS shut down a loophole. It enabled the “wash-sale” rule to remain legal for anyone looking to sell a deflated stock to create a capital loss only to buy it back up again. They do this in order to reap the benefits of an anticipated rebound in value.
Taxpayers used to be able to do that with investments in their portfolio that were under-performing but started to trend upward. They would sell it off fast to write-off the loss, only to purchase it shortly thereafter. Thus, they enjoyed the gains of the increase in value. It was the classic case of having your cake and eating it too.
Those days are over now. The IRS shut that whole thing down. They added a new provision. Individuals are prohibited from claiming a loss on the sale of a security only to buy up a nearly identical one within 30 days.
Therefore, let’s say you sell the shares in a stock and then buy it back again the next week once the stock splits. In that case, the IRS will be fully aware that you’ve purchased the same security again. If you want to claim the write-off you must wait 31 days from the date of sale to buy it back.
In that time the stock could soar in price. You may end up losing more money than you would be saving through the tax break. There’s an inherent risk in this strategy. Thus, you need to weigh the benefits of claiming the loss against ownership of the security.
That’s why it’s important to understand claiming capital losses. They’re meant only to mitigate some of the damage that’s been done when it comes to your profits for the year. They are not designed to be the solution to building significant wealth. There are other ways to do that when you’re strategizing your investments.
More Impacts on Your Taxes
We’ve seen the many ways that capital gains and capital losses can affect your taxes and investment plans over the course of the year. Yet, those are just some of the considerations you’ll need to address in managing your investments.
You need to keep an eye on the consequences that might emerge based on your earnings and losses. In fact, your taxes could be affected in a number of other ways you may not have even thought of. The type of investments you’re holding can play just as significant a role.
Money that is put away for retirement usually comes with some form of a tax break on contributions. You’re not expected to pay an income tax on investment gains. Additionally, some income is only tax-deferred. That means you will need to pay taxes on it once you start drawing down payments on the money you’ve saved. Then you’ll be expected to pay taxes on those gains.
Conversely, there are some plans that allow you to avoid paying any tax on gains that are earned. That’s as long as you know what the stipulations are for that particular type of account. Funds deposited into a Roth IRA won’t provide you with any sort of tax deduction from your contributions. However, when withdrawing from the account, you won’t pay a tax on your initial deposit nor on the money you earned from the investment.
Income from Tax-Exempt Investments
There are some investment options available where you can earn tax-free interest income on your money. Such investment ideas are ideal for taxpayers situated in higher income tax brackets. Though, their interest rates are on the low end.
Hence, your return isn’t as lucrative as what you may find with alternative investment vehicles. As an example, municipal bonds are popular among filers who have high incomes each year. That’s because they won’t be required to pay any taxes on them.
Plus, buying them in the state in which you reside allows you to skip any local, state, and federal taxes when you file your returns. The same is almost true with U.S. Treasure Issues. With them, you’re expected to pay federal taxes on the interest that accrues. However, you won’t be expected to pay anything at the state or local level on that money.
Income from Investments in Collectibles
Investing large sums of money isn’t reserved solely for buying property, real estate, or securities. You can also invest in many other forms of valuable commodities. These include art and other collectibles that certain people may treasure. They will enjoy a significant profit while they’re at it. These sorts of investments can have high gains associated with them.
Perhaps you’re one of those people who prefer putting your money into antiques instead of the stock market. In that case, the IRS has established certain rules for taxing your long-term gains in this type of investment.
They’ve capped the rate at 28% on long-term holding periods. Thus, if you are in a tax bracket of 28% or higher, that’s the tax rate on your gains. Any bracket of 25% or under will mean your gains are taxed at the ordinary income tax rate. These are set forth for gains earned on the sale of collectible assets.
Income from Dividends
Ownership of stock means you have a stake in that corporation. Therefore, you are entitled to share in any of the company’s profits. Nevertheless, the company in which you own that stock has already paid a tax on that income.
You, as the shareholder, are then given a reduced rate when the company distributes qualified dividends as your share. Almost every taxpayer will be taxed 15% on dividends. The maximum rate is the same as that imposed on net capital gains.
Our Final Thoughts
All investors would rather see a gain on their money instead of taking a loss. It matters not how much of a deduction they may be entitled to take on that loss. Now you know how both can have an effect on your taxes. Therefore, you can plan accordingly when making those financial moves with your capital.
Stock Market 101 dictates that you think before you leap. Educate yourself with as much information as possible. That way you won’t sell too early or buy too late. You’ve likely made some inquiries into other facets of the market. These may include seeking out ways to practice socially responsible investing. Also, comparing retirement plans for putting away your hard-earned money for the future.
It’s all too easy to overlook how your taxes come into play with many of these components for investing. Therefore, it’s better to know now what you may be up against. Then, you can hold on to as much of your money as possible for as long as possible. Now that you have the information, it’s up to you to apply it accordingly.