invAll investments and their respective gains or losses have an effect on your state and federal taxes (and possibly even local). To invest profitably, it’s vital that you understand the impact of taxes on your gains and losses. Since your investing monies are called “capital,” the profit you receive from that invested capital is called Capital Gains.
A capital gain occurs when you sell an investment for more than your cost basis — the total you paid to acquire the investment. For example, if you buy stock that costs you $5,000 including commissions, then sell those shares later for $6,500 including commissions, your capital gain is $1,500. That gain is subject to capital gains tax, which, as of 2011, ranges from 15 to 35% of your gain.
Long Term vs. Short Term Capital Gains
The capital gains tax rate you pay depends on how long you held (owned) the investment before selling it.
- Stocks held for one year or more: Are considered long-term capital gains and are subject to the lowest capital gains tax rate — 15% as of 2011 but soon to change (see chart below).
- Stocks held for less than one year: Are considered short-term capital gains and are subject to your ordinary income tax rates, which are determined by your tax bracket. These rates are currently as high as 35% but will climb to 39.6% in 2013.
Because long-term capital gains have traditionally been subject to much lower tax rates than short-term gains, it almost always pays to hold on to any stock you buy for longer than one year.
If you sell an investment for less than its cost basis, you incur a capital loss. Keep track of your losses! You can use them to offset your capital gains tax for a given year. For example:
- If you buy an investment for $12,000 and sell it later for $10,000, your capital loss is $2,000.
- If you incur that loss the same year in which you sold another investment for a $2,000 capital gain, the gain and loss would cancel each other out and you would not be required to pay any capital gains tax.
- If your capital loss was larger than your gain, you’d also be able to carry forward that loss to offset gains you might incur in future years.
Offsetting strategies can be complex, so consult a tax advisor before selling any investment for a significant gain or loss.
Inflation Is Never Considered in Capital Gains
In a stroke of blatant unfairness, the current US Tax Code doesn’t account for gains resulting from inflation. For example, if you invested in a rental home that increased in value the same amount as the inflation rate over a five year period, then decided to sell, you would be taxed on that “gain.” So, even though a gain that results entirely from inflation is not a real gain at all, this pretend gain is taxed. Similarly, gains that do not even keep pace with inflation are still treated as gains when they are, in fact, losses! So if your rental home went up one percent over five years and inflation went up three percent each year, you would STILL be taxed on that one percent as if it were a gain, even though your investment lost ground in real dollars.