When you buy and sell financial securities, you will inevitably generate profits and losses.
The purchase of a stock that runs up 20% provides an excellent source of income, but with income comes taxes.
There are two major tax implications that stock traders need to be aware of, which include long-term and short-term capital gains tax.
Long-term capital gains require that you pay taxes on assets that are held for longer than one year, while short-term capital gains are taxes that are paid on assets held for less than one year.
Within these categories of tax implications, there are several nuances as well as tax levels.
What is important to understand is that depending on the length of your trade, as well as your income tax bracket, you will pay a specific level of tax to the government for profits you incur when you trade financial securities.
With this in mind, you should develop some strategies to optimize your tax ramifications.
Long-Term Capital Gains
Long-term capital gains are generated on assets that are held for more than one year.
To calculate whether a tax gain should be considered a long-term or short-term, you need to count the number of days that you hold the asset including the day that you purchase it to the day you sell it.
Generally, you count beginning the day after you purchased an asset to the day you sell the asset. This number needs to reach 365-days. There are some exceptions to this rule that are published the IRS website relating to gains and losses.
For example, there are some exceptions to real estate as well as commodity futures.
The tax rate that you pay on long-term capital gains is based on your “net capital gain”. Your net capital gain is the total of your long-term capital gains for the calendar year, minus any long-term capital losses.
A long-term capital loss is any loss on an asset that you have held for more than 1-year.
This also can include any long-term capital losses that were carried over from prior years.
Net capital gains are calculated using your costs to purchase an asset.
For example, if you are charged a commission on a stock trade, that amount is incorporated into the price of the shares you bought and sold.
If you purchased real estate any depreciation on the asset or additional costs associated with the sale of the assets such as improvements can be incorporated into the sale or purchase price.
Short-term Capital Gains
Short-term capital gains are derived on positions that are held for less than 1-year.
The tax ramifications are different than long-term capital gains. If you incur a short-term capital gain, your profits are tax at your income tax rate.
Short-term capital gains are included as income in your IRS tax filing and can generate income that takes you into a higher tax bracket. For example, as an individual filing as single, that earns $84,000 has a federal tax bracket at 22%.
If you happen to generate $2,000 of short-term capital gains, you would have an ordinary income of $86,000 which would take you into a higher 24% tax bracket.
Your net short-term capital gain should be calculated including costs such as commissions. It can also be offset by short-term capital losses.
The maximum short-term capital loss that you can declare in a year is $3,000. You can defer a short-term capital loss for up to 3-years.
For example, if you had a short-term capital loss in 2020 of $9,000, you could take $3,000 in 2020, $3,000 in 2021, and $3,000 in 2022.
You can also use a short-term capital loss to offset ordinary income even if you don’t have a short-term capital gain.
Tax Rates for Long-term Capital Gains
There are only a few rates for long-term capital gains.
If you earn an income less than $39,375 as of 2020 your long-term capital gains are taxed at zero percent.
For most people, the net long-term capital gains rate is 15%.
This rate is for individuals filing as single that make less than $434,550 in 2020. There are slightly different levels for individuals that are filing as married or filing individually but married.
If you make more than this threshold, your rate can move up to 20% on long-term capital gains.
There are other exceptions.
Small businesses that have qualified small business stock can have long-term capital gains taxed at 28%.
Additionally, net capital gains from collectibles, such as comic books or art can be taxed at a maximum of 28%. Portions of real estate property can be taxed at 25%.
Developing a Strategy
You want to make sure that you have a trading strategy that allows you to take advantage of long-term and short-term capital gains. One of the best vehicles for short-term trading is an IRA account.
A retirement account is mostly exempt from long-term and short-term capital gains.
This would allow you to trade where you take profits on positions that you hold less than a year and not have to pay short-term or long-term capital gains. An individual that is making $175,000 will pay a short-term capital gain rate of 32% compared to a long-term capital gains rate of 15%.
For every $10,000 in gains, this would equal $1,700.
Another concept you should take into account is netting your long-term capital gains that are not in a retirement account. One way to offset long-term capital gains is to generate long-term capital losses.
For example, at the end of a calendar year, if you know that you will have long-term capital profits of $50,000 and you have an unrealized loss in your account of $25,000, you might consider selling this position to realize the loss to offset your long-term capital gains.
To recap, a long-term capital gain tax rate is based on positions that are held for at least one year. There are several rate levels which include zero for people that make less than $39,375 and 15% for people that make below $434,550.
This differs from short-term capital gains which are considered income and taxed at your ordinary-income bracket rate.
It’s important to develop an investing tax strategy. This should include using a retirement account for short-term trading, where you would consider taking profits in a period that is less than one year.
You should also consider generating long-term capital losses in some cases if you know you will be subject to long-term capital gains.