Capital Gains and You

Follow this one simple rule to minimize your tax bill:

Before the year ends, find your net long-term, and net short-term positions. If you have a short-term loss, and a long-term gain, realize short-term gains to eliminate your short-term loss.

You should never net long-term capital gains with capital losses (short-term or long term). Doing so decreases your tax liability at the lower capital gains rate. Instead, net any capital losses that you have for the year with short-term capital gains. This allows you to realize gains in the short term while decreasing your tax liability by the higher regular-income rate. Read on for some explanation.

What are long-term and short-term capital gains?

Capital gains occur when you sell shares for more than you paid for them. If you sell your shares for less than you paid for them, you incur capital losses.

Long-term capital gains are the profits made from selling shares you've held for at least one year. Profits from shares you held for less than one year are short-term capital gains. Likewise, capital losses are classified as long-term or short term depending on if you held those shares for more or less than one year.

What are net capital gains/losses?

Net capital gains and losses are the numbers that matter when filing your tax return. Calculating your net capital gain/loss is a complicated topic, and other people have already explained it well: * Netting Out Capital Gains and Losses on Schedule D * Ten Important Facts About Capital Gains and Losses * Capital Losses and Tax

How do net capital losses affect me?

Capital losses are deducted from you income for tax purposes. The effect is the same if they are long-term or short term capital losses.

Scenario A (no investments) * Wage income: $50,000 * Tax liability (single in 2014): $8,363

Scenario B (losses) * Wage income: $50,000 * Net capital losses (short-term or long-term): $1,000 * Taxable income: $49,000 ($50,000 - $1,000) * Tax liability (single in 2014): $8,113

In the example above, the taxpayer is in the 25% tax bracket. The $1,000 deduction results in the taxpayer's tax bill decreasing by $250.

How do net capital gains affect me?

Capital gains are taxed as normal income if they are short-term or at a lower rate if they are long-term.

Scenario C (no investments) * Wage income: $50,000 * Tax liability (single in 2014): $8,363

Scenario D (short-term gains) * Wage income: $50,000 * Capital gains (short-term): $1,000 * Taxable income: $51,000 ($50,000 + $1,000) * Tax liability (single in 2014): $8,363 + $250 = $8,613

Scenario E (long-term gains) * Wage income: $50,000 * Capital gains (long-term): $1,000 * Taxable regular income: $50,000 * Taxable capital gains income: $1,000 * Tax liability (single in 2014, CG rate): $8,363 + $150 = $8,513

In the example above, the taxpayer is in the 25% tax bracket for normal income and the 15% tax bracket for long-term capital gains. By waiting until his gains become long-term, the investor could save $100 on his tax bill.

Why shouldn't I net short-term losses with long-term gains?

Income falls into two buckets for taxation purposes: regular income and long-term capital gains income. Regular income is taxed at ~30%. Capital gains are taxed at ~15%. Short term losses are deducted from long-term gains before they are deducted from regular income. If you have the option, you should make you short-term losses deduct from your regular income instead of you capital gains income.

Scenario F * Wage income: $50,000 * Capital losses (short-term): $1,000 * Capital gains (long-term): $1,000 * Taxable regular income: $50,000 * Taxable capital gains income: $0 * Tax liability (single in 2014): $8,363 * Effective tax rate: $8,363 / $50,000 = 16.73%

Scenario G * Wage income: $50,000 * Capital losses (short-term): $1,000 * Capital gains (long-term): $1,000 * Capital gains (short-term): $1,000 * Taxable regular income: $50,000 * Taxable capital gains income: $1,000 * Tax liability (single in 2014, CG rate): $8,363 + $150 = $8,513 * Effective tax rate: $8,513 / $51,000 = 16.69%

By realizing short-term gains to net against your short term losses, you increase your income for the year while lowering your effective tax rate.

Kurt Tomlinson does not hold himself out as providing financial advice. Kurt Tomlinson also does not make any recommendation or endorsement as to any investment, advisor or other service or product or to any material linked to this website. In addition, Kurt Tomlinson does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy.

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