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 | Kiplinger Community Tax Forum | ||
| Publication 550, Investment Income and Expenses | ||
| Publication 544, Sales and Other Dispositions of Assets | ||
| Schedule D Instructions | ||
So you had a good year in the stock market and want to cash in some of the gains. Well, be prepared to share some of your good fortune with Uncle Sam. That is, unless you sold some losers in your stock portfolio to offset some of your profits.
The tax tail should never wag the investing dog, but failing to consider the tax consequences of your investing activities could cost you, or at least knock some of the shine off your glowing returns. Here are some tax issues that affect every investor, and a few tips to help you keep more of your money:
- Dealing with gains and losses
- Reporting dividends
- Tax-free interest
- Writing off worthless stock
- Inherited assets
- Wash sale rule
Dealing with gains and losses
You do not owe capital-gains tax until you sell assets (stocks, bonds, mutual funds, real estate, etc.). Once you "realize" a capital gain, the tax is computed on the difference between your selling price and the basis, or original cost, of the shares.
Long-term capital gains (the profit from assets held more than a year) are taxed at 15% for those in the 25% or higher tax bracket; taxpayers in the 10% or 15% brackets pay just 5% capital-gains tax.
Short-term capital gains are taxed at your regular income-tax rate (up to 35%).
The law allows you to use capital losses to offset capital gains dollar for dollar -- first subtracting short-term losses from short-term gains (investments held one year or less), then subtracting long-term losses from long-term gains (investments held longer than one year). Then use any remaining losses to offset any remaining gains in the other category.
If you still had more losses than gains, you can deduct up to $3,000 in losses against other kinds of income, such as your salary. Any losses beyond that are carried over to the next year, in which you can first use them to offset capital gains. Then, if you still have more losses left over, you can deduct up to $3,000 of them from your income. You can continue this process every year until you've finally deducted all of your losses.
The only limit on how much carry-over loss you can use in one year is how much gain you have to offset.
When you file your return, you'll need to report your capital gains and losses on Schedule D, which has a worksheet to help you with the calculations.
Reporting dividends
If you received dividends, you'll get a Form 1099-DIV from you mutual fund or broker showing how much you received what part, if any, represents "qualified dividends." That's important because qualifying dividends qualify for special tax rates: no more than 15%, and just 5% for taxpayers in the 10% or 15% tax brackets. Nonqualifying dividends are taxed at your regular tax rate, as high as 35%. You report both ordinary and qualified dividends on the Form 1040; ordinary dividends also go on Schedule B; and you figure the tax on your qualified dividends on "The Qualified Dividends and Capital Gain Tax Worksheet" in the Form 1040 instructions. You must use the worksheet to get the benefit of the special rates.
Generally, dividends on common and preferred stocks of publicly held or closely held U.S. companies will qualify for the lower rates. Dividends from foreign companies are also taxed at the lower rate if they're traded on a U.S. exchange, the company is incorporated in a U.S. possession, or the company is based in a country that has signed a tax treaty with the U.S.
Dividends from bond mutual funds are considered interest and are taxed at ordinary-income rates. The same goes for dividends from money-market and REIT funds.
What about borrowing to buy dividend-paying stocks, so you can deduct interest on the loan in your top bracket and pay tax on the dividends at just 15%? Don't bet on it. Interest on such loans is deductible only to the extent that you report taxable investment income. And Congress was careful to say that dividends taxed at 15% don't qualify as investment income for this purpose.
How about buying stock or mutual fund shares just before they pay low-tax dividends and then selling right afterward for a loss (because the price falls to reflect the payout), up to $3,000 of which could be deducted in your top bracket? Again, the lawmakers are ahead of you. You have to own a stock or fund for at least 60 days in the 120 days before or after the ex-dividend date for the payout to qualify for special treatment. This rule is expected to cause heartburn at tax-return time.
Tax-free interest
Most investors in U.S. government securities -- such as Treasury notes and bonds and U.S. savings bonds -- know that the interest earned is tax-free on their state returns. Some income paid by mutual funds gets this state-income-tax break, too. Some money market mutual funds invest heavily in U.S. government obligations, so a substantial portion of the income they pay during the year is state tax-free. Some bond funds invest solely in U.S. government securities, so all of their income dividends are state tax-free.
You even can get state-income-tax-free income from stock mutual funds because the portion of the fund's assets held in cash may be invested short-term in government obligations. The interest earned and passed on to shareholders may be state-tax-free.
Your funds should have advised you what portion of your income dividends may be state tax-free. That valuable information doesn't come on the 1099-DIV form that reports income, but in a separate document. Check your records or call the fund's toll-free number for details.
Writing off worthless stock
In most cases you can't deduct a loss on a stock unless you "realized" it by selling the shares before the end of the year. The IRS just doesn't want to hear about your "paper" losses.
But there is an exception to that rule. You can declare a stock worthless the year the stock became wholly worthless and deduct its entire cost. Just because a company went bankrupt doesn't mean the stock is worthless. The IRS says that if there's any chance a stock can recover, it's not wholly worthless.
Some advisers say the stock is not worthless if it still shows up trading on the pink sheets with an asking price of a fraction of a penny per share. But according to an experienced CPA and a long-time IRS employee, if your block of stock would bring less than the broker's commission for selling it, then they'd claim a worthless stock deduction -- assuming they had evidence that the company met its demise.
To write off a worthless stock, you report it on Schedule D as though you sold it for $0 on December 31. That date also determines whether you have a short- or a long-term loss. In the section where you're asked for the sale date and selling price, just write "worthless."
Inherited assets
If you sold assets that you inherited, you deserve a special tax break. Inherited property enjoys a "stepped-up" basis. That is, your basis is generally the value of the property when the previous owner died. The tax on any appreciation during his or her lifetime is forgiven.
You are taxed only on appreciation after you inherit the asset. And, if the asset has declined in value since you inherited it, you may claim a tax-saving loss deduction even though you're clearly financially ahead. The gain or loss from the sale of inherited property is automatically considered long-term, regardless of how long you owned the property before selling it.
Wash sale rule
You can't deduct a loss if you buy the same stock within 30 days of selling it. You also can't deduct the loss if you own it for less than 30 days. It's called the "wash sale" rule.
The good news is that if you do buy the stock back within 30 days, you don't lose the loss forever. A loss denied by the wash-sale rule is added to the cost basis of the newly purchased shares. That will lower your tax bill when you eventually sell the repurchased shares.
For example, say you bought 100 shares of Fancy Stock for $1,000 and sold them for $750. Less than 30 days later, you think Fancy Stock is poised for a take-off and you can't wait any longer to buy 100 shares at $800. You can't deduct the $250 loss in the year of the wash sale, but you can add it to your basis. When you finally sell Fancy Stock, your gain or loss would be calculated using an adjusted basis of $1,050 ($800 plus $250).
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