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Home » Invest, Taxes

Capital Gains Taxes 101: For Anyone who Buys and Sells Investments

Last updated by on 12 Comments

Capital gains tax rules do not make for a particularly thrilling topic.

But… seeing that this is a personal finance blog geared towards young professionals and we should all be investing as early as possible, capital gains (and losses) as they pertain to market investments are something I wanted to do a 101 type overview of. And what better time than tax season?

If you buy and sell investments, you need to know capital gains basics or you are at risk of significant losses through bad tax planning, an IRS audit if you calculate things wrong, or worse.

This won’t be a complete guide to capital gains taxes, but hopefully it gives you a respectable background on the primary things that should be top of mind when it comes to investing and taxes, so that you can do further research when necessary or be more informed on questions you take to a tax professional or the IRS.

Capital Gains Start with Cost Basis

capital gains taxesWhen you purchase an investment asset (i.e. a stock unit that has fully vested or stock in a taxable investment account), what you pay for that investment is your cost basis. So if you buy 1,000 shares of stock “Chatch & Sons Inc.” at $10 per share, your cost basis for those shares totals $10,000.

Note: you can also factor in the cost of the sale transaction in to your cost basis (i.e. $10 commission would subtract $10 from your cost basis).

The cost basis is what you use to calculate whether you have a capital gain or capital loss when you sell your asset, and how much those gains or losses are.

Capital Gain Vs. Capital Loss

When you sell a capital asset, you either have a:

  • capital gain: when the price at which you sell is more than the price at which you purchased the asset
  • capital loss: when the price at which you sell is less than the price at which you purchased the asset

Calculating capital gains and losses is fairly simple, if you don’t purchase and sell often.

For example, lets say your 1,000 shares of Chatch & Sons appreciated to $15 (up from $10) per share. Your total proceeds from selling would equal $15,000. Your cost basis was $10,000. So your capital gains would be $5,000 ($15,000 proceeds minus $10,000 cost basis).

If, on the other hand, your Chatch & Sons shares declined to $5 (down from $10) per share, you would be left with only $5,000 if you sold the shares. Since your cost basis was $10,000, you would realize a capital loss of $5,000 ($5,000 proceeds minus $10,000 cost basis).

Cost Basis Methods & Reporting

If you do purchase shares often, the math isn’t quite so simple. It used to be that you had to calculate the gains/losses on your own. However, recent legislation now (thankfully) requires brokers to do the calculations for stocks purchased in 2011 or later, and mutual funds and most ETFs purchased in 2012 or later and provide them to you through a 1099B form.

There are a number of different ways that cost basis can be calculated when you have a large number of shares. I won’t go in to all of the details here (the Boglehead wiki covers it well), but the industry standard default for stocks and mutual funds typically are:

  • Stocks: first in, first out (FIFO) – in this method, the first shares purchased are assumed to be the first shares sold.
  • Mutual funds: average cost – in this method, you calculate the average cost of all shares that were purchased that are being sold, and use that as the basis.

Short-Term Vs. Long-Term Capital Gains & Losses

There are two types of capital gains or losses:

  • short-term: capital gains or losses are considered “short-term” if the asset was held for less than a year.
  • long-term: capital gains or losses are considered to be “long-term” if the asset was held for more than a year.

The difference between the two is SIGNIFICANT when it comes to capital gains. What you ultimately pay in taxes on gains will be influenced by how long you held the asset.

Short-term capital gains are taxed at your ordinary income rate. Long-term capital gains, on the other hand, get preferential tax treatment at levels that are below ordinary tax rates.

An important takeaway is that if you are considering selling an investment that has increased in value, it might make sense to continue holding it until at least the 1-year mark for the capital gain to be considered long term (when your taxes could potentially be lower, depending on what bracket you are in). Consider this as something for you to be aware of and look in to. More on this in a bit.

Capital Gains, Losses, & Taxes

If you have both capital gains and capital losses in the same calendar year, the losses cancel out the gains when calculating taxable capital gains.

For example, if you have $5,000 in capital gains and $3,000 in capital losses, you would only pay taxes on the $2,000 in capital gains you netted.

If your capital losses were greater than your capital gains in the same calendar year, you would actually be able to deduct your capital losses, up to $3,000 per year ($1,500 for a married individual filing separately).

Capital losses exceeding $3,000 can also be carried over into the following year and subtracted from gains for that year (or deducted if left with a net negative). This is called a “capital loss carryover“.

Can you Carry a Capital Loss Carryover Beyond 1 Year?

Many people think that you can only carry over 1 year. However, that’s not true. You can continue carrying over the capital loss until it is 100% used up or if you make gains in the subsequent years the remaining losses can cancel out the gains.

For example, if you have a capital loss of $21,000 in one year, you could take a deduction of $3,000 in that year and $3,000 each of the next six years (for a total of $21,000 in deductions). If you had a gain of $10,000 in year 2, you would subtract $10,000 in capital losses, and then carry over the remaining capital loss balance to future years until it was depleted.

Netting Out Capital Gains & Losses (Short Vs. Long-Term)

What happens when you have a net gain in the short term category and a net loss in the long term category, or vice versa? You net the two against each other, and the remaining gain or loss is taxed according to its character (short term or long term).

Capital Gains Tax Rates:

Here is the difference between how short and long term capital gains are taxed at each tax bracket:

Ordinary Tax RateShort-Term Capital Gains Tax Rate (held <1 year)Long-Term Capital Gains Tax Rate (held 1+ year)
10%10%0%
15%15%0%
25%25%15%
28%28%15%
33%33%15%
35%35%15%
39.6%39.6%20%

Capital Gain Tax Forms

Brokerages are now required to send you capital gain and loss reporting via a 1099B form, so that you do not have to calculate everything on your own.

From there, your capital gains and losses will be calculated on IRS Form 8949 and reported on the IRS’s 1040, Schedule D form.

That wasn’t so bad, was it?

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12 Comments »
  • Mike F says:

    Cost basis also includes any commissions on the trade you are charged. So if you pay a $7 commission of 1,000 shares of a company worth $10 per share then your cost basis is $10,007.

    On the sale, you deduct the commission from the proceeds so if you sell it at $10 per share, your proceeds are $9,993 so you still have a $14 capital loss.

  • Nathan says:

    G.E.,

    Good stuff, as always.

    It is interesting to note that if you are an investor who holds a stock (ideally, an ETF) for longer than a year and are within a 10-15% tax bracket, you could essentially turn a “taxable” TOD or Joint account into a Roth IRA in that – upon your sale – you would pay NO taxes on the capital gains. Dividends are also tax-free if they are qualified and you are within a 10-15% tax bracket.

    With a high-yielding dividend ETF, you could theoretically turn your “taxable” investment account into a cash-producing machine that was spitting out 4-5% of dividends each year in the form of tax-free income to you! And as long as you never sold it, you wouldn’t pay any capital gains tax, either.

    So as an investor in a 25% bracket, you may actually be better off contributing to a Traditional IRA or 401(k) to lower your AGI to within a 15% tax bracket, then investing the rest of your money into a taxable account. As long as your income doesn’t go up above the 25% mark, you will get completely tax free distributions from that account. Plus, there is no age restriction like there is with retirement accounts (59 1/2).

  • Kyle says:

    I was just wondering about the specific tax differences between a S.T. capital gain & a L.T. capital gain due to buying & selling stocks on a 30 day plan. Now, I understand much better. Great info… G.E.

  • Ted says:

    GE,

    Long time reader, first time commenter. Nice, concise article.

    Any thoughts on strategy as far as selling holdings periodically to break up capital gains taxes? This only really applies in bull markets, but over the last few years all my ETF/fund holdings have just continued to go up. Once a year or more has passed I’ve wondered if there is any point to selling each holding every 2-3 years simply to avoid paying a hefty tax on a 50 or 100% gain that may occur over a longer period of 5+ years. Any considerations there?

    • G.E. Miller says:

      If you don’t need the income now, why not just keep adding to your positions until you need it? If that isn’t until retirement, there’s a good chance your income will dip, and you will be in a lower tax bracket (with a lower capital gains rate).

  • MC says:

    Very timely information. Thank you!

  • Tyler says:

    Question about long-term vs. short-term capital gains. If I put $100 a week into a mutual fund, and after 5 years sell 80% of my outstanding shares, how is that taxed? It is assumed that the shares I sold were the first shares purchased, so as long as I sell less than 80% of the shares (four years worth of purchases over a 5 year period) it is taxed at the long-term rate? What if I sell all the shares, including those I bought last week?

    Thanks for antoher great article!

  • David says:

    Another thing to mention: if you make a lot of money (owe a lot of capital gains tax) you will have to file and pay taxes quarterly.

    So if you make enough to owe $x or more in capital gains tax (minus your estimated end-of-year return), you must file and pay that amount during that quarter. For federal, it’s $1,000 and for state (at least in MD) it’s about $500.

    Like I mentioned, you’d have to make a lot of money to qualify. The amount is also after subtracting your estimated end-of-year return, for which our accountant recommended using last year’s return. But if you’re rolling in cash, big brother wants their cut early. ;-)

    D

  • Brandon says:

    This makes me question whether a 401k/ira is a good investment. Let’s say your income tax bracket is 25% and capital gains is 15%. If you had a traditional investment, you would have paid 25% on the contribution and 15% on the gains. If you had a 401k, you would pay 25% on the contribution (when you sold the stock out), and you would pay 25% on your gains. Am I missing something here? I understand there’s a benefit to having your money grow on the pre-tax amount.

    To a throw a further complication in it, what if you think taxes will be 50% in the future? Wouldn’t this mean that traditional investment would be better than the 401k–25%/15% tax vs 50% tax on everything when you sell (even if it did grow a little more)?

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