Stocks and Taxes: What You Have to Pay, When

If you play the stock market (if you’re no longer shell shocked by the volatility of the past couple of years) you may want to know a little about the taxability of your securities transactions.

Capital Gains Tax 

Any profit you enjoy from the sale of a stock held for at least a full year is taxed at the long-term capital gains rate, which is lower than the rate applied to your other taxable income.  It’s 15% if you are in a 25% or higher tax bracket and only 5% if you are in the 15% or lower tax bracket. Profits from stocks held for less than a year are taxed at your ordinary income tax rate.

Ordinary dividends earned on your stock holdings are taxed at regular income tax rates, not at capital gains rates. However, “qualified dividends” are taxed at a very advantageous capital gains rate of 0% to a maximum of 15%. For dividends to be classified as “qualified” they must be paid by a U.S. corporation or a qualified foreign corporation and the holding period of the stock must be more than 60 days. There are plenty of other exceptions and definitions, so check with your broker or tax advisor to see if the dividends for your stock holdings are “qualified.” Dividends on stock held in a qualified retirement plan are not taxable income.

I believe Congress enacted the lower capital gains rate to drive investment. After all, most tax laws are passed as a form of directing social behaviors. Be sure to follow what happens to the capital gains rate during the course of the next several months. President Obama has thrown out the idea of raising the capital gains tax rate many times, although nothing has happened yet. In fact, at this writing, the talk is that the current rates will remain in effect for the next two years. If that doesn’t happen and as a year-end tax tip, I advise you to sell appreciated stock held more than a year while the lower rates are in effect.

Stock Sales

When determining your profit from a stock sale, it’s important to understand not only the formula, but the meaning of the variables in the formula. Certain circumstances applied to the variables can reduce your tax liability when you sell. Many taxpayers believe they must pay taxes on the full amount of the check they receive from the sale--not true. You can subtract your basis.

The formula is: Sales Proceeds – Basis = Taxable Profit or Deductible Loss

Sale proceeds can be reduced by commissions paid to the broker.

Basis is the cost of the stock plus any reinvested dividends and commissions paid for acquisition. If you inherited the stock, the basis is the fair-market value of the stock on the date of the decedent’s death or the alternate valuation date. If the stock was received as a gift, the basis is the lower of the fair-market value or the basis of the donor at the time the gift was made.

The Wash Rule

Many investors benefit from selling a stock in a losing position to offset a gain, then turn around and buy the stock right back.

However, the IRS will not allow an investor to claim a capital loss if you sell a stock and buy it back within 30 days. The “wash rule” prevents you from claiming a loss on a sale of stock if you buy replacement stock within the 30 days before or after the sale and you will lose the offset.

Capital Losses

One of the big limitations in stock investing is the amount of losses you are allowed to deduct on your tax return. If you sell stocks at a loss, you may deduct only $3,000 per year; the remainder of the loss is carried forward to future years. You may apply capital losses against capital gains in the current and future years to net out the overall profit or loss.

Deductible Investment Expenses

A tax deduction often overlooked by investors is the cost of management fees paid to brokers, usually for management of mutual fund accounts or for advisory services. You may deduct these fees as an investment expense on Schedule A of your tax return. Some brokerage 1099s or year-end statements will state the total for the year, but many do not. You may have to call your broker to find out how much you paid.

Audit Taxpayers oftentimes forget about a stock sale when compiling their income tax return, which results in the IRS sending a CP-2000 letter. The letter is about 12-pages long and somewhere in the middle is a listing of omitted items and a calculation of the tax liability on those items. If you receive one showing an omitted stock sale, don’t just pay the tax bill. The IRS only knows about the stock sale; they have no clue as to what your basis in the stock is. Remember the formula earlier? You may actually have taken a loss on the stock and that means no tax liability whatsoever. In fact, you may be entitled to a refund. So call the phone number on the front of the letter and let them know that you will amend that tax return.

However, beginning Jan. 1, 2011 as a part of the Emergency Economic Stabilization Act of 2008, brokerage firms will be required to report the cost basis and gain/loss information to the IRS on their form 1099, which will be issued in 2012. This will streamline the tax preparation process considerably and result in accurate CP-2000 letters being sent to taxpayers. It will also cut down on the number of amended tax returns that need to be filed as a result of omitting stock sales.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook