Taxes on Stocks

When you think of capital gains taxes, the first thing that jumps to your mind is probably taxes on the trade of stocks. Stocks are considered a capital asset, meaning they are taxed like regular capital gains. In this article, we’ll go more in depth on how the trade of stocks is taxed. Be sure to check out our article on capital gains taxes first to get a better understanding of the general principles the IRS will apply to your trades.

Calculating Capital Gains Taxes from Stock Sales

Gains and losses from stocks are not recognized until they are traded, just like all capital gains. This means that if you buy 50 shares of Amazon stock for $100, the value of those shares increases to $150, but you don’t sell any shares, you would recognize no capital gains or losses on those shares. Keep in mind that as a capital asset, you must hold onto stocks for more than one year for the lower long-term capital gains tax rates to apply; otherwise, the cash earned from this sale will count towards your general income tax.

The same logic applies if that same Amazon stock were to decrease in value; the loss is not recognized as a capital loss unless you sold the stock. Though selling stock at a loss may seem counterintuitive, especially if you expect that stock to increase in value, there are some methods by which this can reduce the overall amount of taxes that you owe.

One such method is by trading stocks within a retirement account such as a 401(k) plan or an IRA. Since these are tax-sheltered accounts, trades withing the accounts do not count towards capital gains. You will still have to pay taxes on the money when you withdraw it, however, depending on the type of account.

Since capital gains taxes are calculated from net gains, capital losses will reduce the amount of taxes that you owe. As such, selling stocks or securities at a loss around tax time is one way to reduce your investment income, and therefore how many dollars in taxes you owe to the IRS. This is called Tax-Loss Harvesting. The obvious disadvantage of using this method is that you reduce the overall value of your portfolio. While you can repurchase similar stock, this puts you in danger of illegally reporting losses from a wash sale.

Wash Sales

Wash sales occur any time you trade stock or securities at a loss and then buy “substantially identical” stock or securities withing 30 days before or after the sale. For example, if you bought 10 shares of Intel stock for $300, sold them for $200 after the price dropped, and then bought another 10 shares of the stock for $225 only 20 days later, you would have just completed a wash sale.

Nothing is inherently illegal about wash sales themselves, but they do have important implications for reporting your capital gains and losses. Losses from a wash sale do not count towards your capital losses. This prevents you from making a wash sale around tax time in order to artificially lower your capital losses. In fact, doing so is illegal.

However, there are still ways to apply the loss from a wash sale to your capital gains and losses legally:

1. Add the losses to the cost of repurchased stock for next year’s filing. The losses from a wash sale may be added to the cost of the new stock. Referring to our Intel stock example, the $100 that you lost from the initial sale of the stock can be added to the repurchase price of $225. This means that you effectively purchased the stock for $325 for future tax reporting purposes. When you eventually sell that stock, that artificially increased price will lower the amount of capital gains that you have to recognize on its sale.
2. Repurchase stock that is not substantially identical. Generally, bonds and preferred stock of a company are not substantially identical to their common stock. If, however, it is easy to convert common stock to preferred stock, or the voting rights are the same, then the IRS considers them to be substantially identical. Additionally, stocks of a different company or an ETF managed by a different company are not considered substantially identical, even if the prices are similar. Be warned that the IRS may change this in the future, so it’s important to keep your eye on the tax codes if you intend to tax loss harvest.

Conclusion

Generally, these rules apply to stock options, common stock, preferred stock, ETFs, bonds, and other securities. If you own stocks that pay dividends, that income is reported differently. Be sure to check out our investment income article for more information about that.

Do you feel as though the IRS has made a faulty opinion which you need to challenge? Contact Cornerstone Law Firm today. The experienced tax attorneys can help you challenge an IRS decision to make sure you don’t pay more than you owe. After all, it’s your right to challenge the IRS and to not pay more than you owe as outlined by the taxpayer bill of rights.