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Wednesday, January 12, 2011

Capital Gains Tax Tip - When Do You Pay Taxes on Stock Trading?

Stock trades are taxed as capital gains, instead of regular income. They are computed on the IRS Schedule D form, and follow different rules than the income from a job.

This article presents an overview of the process:

1. Taxes after sales - No taxes are paid until after a stock is sold - when it can be determined whether a gain or loss occurred. In other words, if you only buy stocks and never sell them, you will never owe a tax!

2. Cost basis - This is the method used to figure out which shares were sold. For example, if you bought 10 shares of stock ABC at $10, another 10 shares at $15, and then sold 10 shares at $12, do you have a gain of $2 per share, or a loss of $3 per share?

If ABC was a mutual fund, then the cost basis is easy - it is simply the average of all shares purchased. In our example, the cost basis would be $12.50 per share, so we would have a loss of 50 cents per share.

With stocks and Exchange Traded Funds (ETF's), the IRS does not allow us to average the costs basis. Instead, we can select from the LIFO or FIFO method. You choose separately for each stock but, for any one stock, once you choose FIFO or LIFO, you can not switch to the other.

The LIFO (Last In, First Out) method matches shares that are sold with the last shares bought and works backwards. So, in our example, the 10 shares we sold were from the $15 batch, so we have a $3 per share loss, and we have 10 shares left with a cost basis of $10.

The FIFO (First In, First Out) method matches shares that are sold with the first shares bought and works forwards. So, in our example, the 10 shares we sold were from the $10 batch, so we have a $2 per share gain, and we have 10 shares left with a cost basis of $15.

3. No Social Security or Medicare Taxes - Capital gains are not subject to these taxes.

4. Long term vs. short term capital gains - Any stock held at least one year and one day are considered long term capital, and are taxed at a lower rate. Any stock sold earlier is considered short term, and is taxed at the same rate as your regular income.

5. Capital Loss Limit - If, after adding up your stock market gains and losses, you have a loss larger than a certain limit ($3,000 at the time of this article), then you can only subtract this limit from your other income. You have to carry over the rest of the loss to the next year.

For example, if you made $40,000 in your job and lost $40,000 in the stock market, you cannot say that you made $0 for the year. Instead, you have income of $37,000 and you have to carry over $37,000 in stock losses to future years.

6. Wash rule - If you sell a stock for a loss and count it as a capital loss, then you cannot buy the stock back until at least 30 days have passed.

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