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.

Tax Benefits of Forex Trading

Forex trading allows you to have the best of both worlds. When stock prices go up, you can benefit from Forex trading. When stock prices go down, you can profit from Forex trading.

Inflation goes up, you can profit from Forex trading. Inflation goes down, you can profit from Forex trading. Similarly, interest rates can go up or down, you will profit from Forex trading.

You have to pay a capital gains tax for any investment in financial markets. Capital gains will be considered short term if it is less than one year. Short term gains are taxed at your current tax rate.

And if you hold the security for more than one year before you take profit, you will have to pay long term capital gains tax. Long term capital gains are taxed at a rate of 15% only.

But if you invest in Forex markets, 60% of your profits will be taxed as long term gains and only 40% will be taxed as short term capital gains whether you hold a currency for one minute, one hour, and one month or more.

Lets take an example. Suppose you invest $10,000 in stocks and $10,000 in Forex. Your tax bracket is 33%. Suppose you made a profit of $10,000 in both stocks and Forex each in six months.

Since your stock investment was less than one year, your profit will be treated as a short term gain. That means you will have to pay your current tax rate of 33% which will be (10,000)(0.33)=$3,300 and your profit after taxes will be only $10,000-$3,300= $6,700.

It doesn't matter whether you took profit in six months or one year in Forex, 60% of your profit will be treated as long term capital gains and 40% will be treated as short term gains. It means 60% of $10,000 will be taxed as long term capital gains at only 15% which is (0.6)(10,000)(0.15)=$900.

40% of your profits in Forex will be taxed as short term capital gains at your current tax rate of 33% which calculates as (0.4)(10,000)(0.33)= $1,320.

So the total tax that you pay on your Forex investment will be ($900) + ($1,320) =$2,220. But your tax on stock investment was $3,300 which is $1100 more than the tax on the same capital gain on your Forex investment.

Tax savings on Forex investment like that can add up fast. Profits can accumulate quickly by investing in the Forex market within your IRA or other tax-deferred retirement account.

Capital Gains Tax Rates in the UK

It is mandatory to pay capital gains tax if you dispose of any asset by transferring or giving it way. You are also subject to paying the CGT if you receive compensation, for example, you may receive compensation for a damaged good from an insurance company.

You do not have to pay any capital gains tax on the sale of your car, and first home, under most conditions, ISAs or PEPs, UK government gilts (bonds), income from betting, lotteries or pool winnings, or in other words, any money that is already subject to income tax.

Calculating the CGT:

When you sell an asset: Let us assume you bought some shares for £1000 and you sold them for £2000. You would need to pay CGT on the gain which in this case is £1000.

When you give an asset: It is important to point out that you need to pay CGT on the value of the asset and not what you get from it. To illustrate this, let us consider that you bought a flat for your son at £70,000 four years ago and its value has now appreciated to £100,000. Suppose you let him have it at less than the market value, £75,000. Your gain would be £100,000 minus £70,000 which is £30,000.

When you dispose of an asset: If you dispose of an asset which you received as a gift, your gain will be based on the market value when you received it. For example, you are gifted a garage whose value at the time when the gift was made was £5000. Now you sell it for £8000. Your gain in this case will be £3,000.

Avoid A Stock Trading Tax Nightmare! The Importance of Cost Basis for Capital Gains

Most people are used to paying income taxes on regular income from their jobs. However, many people get confused when it comes to paying capital gains taxes on stock trades.

There are no taxes due from buying stocks. In fact, if you held your stocks for the rest of your life, you would never have to pay anything to the government. Taxes only enter the picture when you sell.

At that point, it gets a little tricky. Your broker will then send the IRS a statement showing the proceeds of the sale. It is then important for you to determine the cost basis of those shares - i.e, the price and date that you bought the particular shares you just sold. The cost basis is needed to determine whether you have a gain or loss, and whether the gain/loss is long term or short term.

A long term gain or loss occurs when you have held the stock for at least a year and a day. If you held the stock less than a year and a day, it is a short term gain / loss. This is important because long term gains are taxed at a lower rate than short term gains. This is because the government likes to encourage long term investments, because they create jobs.

If you do not provide a cost basis on your tax return, the IRS will assume you bought the stock for $0 and it was a short term gain. This can cost you a lot of money!

For example, suppose that, in one year, you bought 1,000 shares of GE for $34, sold them for $32, and then used some of the money to buy 1,000 shares of HP for $20. Finally, you sold the HP shares for $22. You have broken even - you lost $2,000 on GE and gained $2,000 on HP.

However, the IRS will get a statement from your broker that you sold $32,000 of GE and $22,000 of HP. If you do not provide a cost basis on your tax return, the IRS will think you earned $54,000! They may come after you for back taxes and interest.

Special Tax Rules on the Sale of Your Home

If you sell your home the IRS rules permit you to exclude up to $500,000 of the gain ($250,000 if you are single) on the sale. In order to qualify for this exclusion you must have owned and used your home at least two years out of a five-year period ending on the date of the sale (known as ownership & use tests). The best part about this gain exclusion rule is that it is not a one-time exclusion. You can exclude gains on subsequent sales as well, as long as you meet the ownership and use tests.

Special rules regarding the capital gain exclusion:

1. Death of Spouse - As long as the sale of your home occurs within two years of your spouse's death, you are eligible for the gain exclusion.
2. Nursing Homes - If you are admitted to a licensed care facility (e.g. nursing home) the use test is relaxed and the time spent in the nursing home will be considered as time spent in your home.
3. Divorce - In order for the divorced spouse not residing in the home, to be eligible for the gain exclusion, the divorce degree must stipulate that the former spouse living in the home, was granted use of the property pursuant to the divorce agreement. If the divorce agreement does not include this provision, then the former spouse, may fail the use test and become ineligible for the gain exclusion.
4. Job Relocation - The rule permits a reduced gain exclusion when the ownership/use tests are not met due to a job exclusion. The gain excluded is prorated based on the number of days of ownership or use divided by 730 days.
5. Rental of a Portion of Your Home - The entire gain may be excluded, however, a portion of the gain attributable to post May 6, 1997 depreciation is subject to a maximum 25% tax rate. This exclusion rule does not apply to two-family homes. In such case only the unit used as a home qualifies.

Tax Saving Strategies with Stock Trading

If you trade in stocks, you need to have tax savings strategies in place, or come April 15, your profits will look a lot smaller after the IRS has taken its share.

However, the good news is that there are certain tax savings strategies with stock trading that you can implement to reduce your taxes.

Although we use investor and trader as we please, in the world of taxes these to words have different meanings and your taxes will be affected according to the meaning you put. Therefore, it is better to understand how the IRS views a trader and an investor so that you can benefit from it.

If you spend you days buying and selling stocks, then you are trader. If you are a trader, you save yourself a lot of money when it comes to paying taxes. As a trader, you can deduct all your investing expenses from your tax returns. These expenses can be newsletter subscription, home office and computer equipment.

Now how can you decide whether you are a trader or an investor? There is no guideline laid out to distinguish between a trader and an investor other than the several court cases. According to these court cases, you are a trader if you spend a lot of time trading and you do not have a regular full time job. But you can also be part time trader but you would have to buy and sell stocks on a daily basis. In addition, you are a trader if you have established a regular and continuous pattern for trades, and you ultimate aim is to profit from short-term market swings rather than keeping stocks for long-term gains.

However, you can be both a trader and investor. But you should separate your long-term investments from your short-term investments so that you are not caught by IRS for cheating.

From the IRS's perspective, a trader is self-employed and you can deduct all your expenses on Schedule C. Write offs in Schedule C reduces your adjusted gross income and you can fully deduct your personal exemptions While an investor has to account for all his expenses on Schedule A, and they can only write off the amount that exceeds 2 percent of the adjusted gross income.

In addition, as a trader you can deduct margin account interest on Schedule C and take an immediate write off of up to $128,000 for 2008 and $125,000 for 2007 for equipment you used in your trading activities for more than fifty percent of the time. Plus, you will not have to pay self-employment tax on your net profit because capital gains are exempt from it.

ETF Trading and Your Tax Planning

The tax efficiency benefit of ETFs (exchange-traded funds) quite often goes unnoticed when considering the other advantages like flexibility, low operating cost, and transparency. Looking towards the end of the year, we need to take stock of how an investor can reduce their tax liability by changing some of their portfolio instruments to ETFs. We will also look at other strategies in ETF trading that can lighten the tax burden. It would be wise to discuss your proposed action with your tax consultant first.

Taxes can have a negative impact on fund performance depending on the quality and timing of management. Even well managed mutual funds have lower tax efficiency than ETFs. Mutual fund managers, to fence in capital gains have been known to sell rather late in the year. The gains to current shareholders would be distributed pro-rata.

The indices tracked by ETFs generally sell and buy securities a lot less often than do mutual funds. There is therefore no need for most ETFs to distribute any year end capital gains to go into the 1099 form for your tax file. The largest suite of ETFs, iShares has never distributed capital gains to its investors. Lucky or astute investors, would you not say!

Another point is that shareholders of mutual funds redeem and purchase shares from the fund which could result in the distribution of gains to the other fund shareholders. An investor could find themselves falling afoul of capital gains commonly called "imbedded capital gains", whereby the sale of an investment made years ago affects a shareholder who was not in the fund then. The ETFs on the other hand sell and but ETFs on an exchange basis without affecting other shareholders. The ETF investor therefore has a better transparency and control on the liability.

These tax advantages that are clear to the eye can also be used as a toll in reducing your tax load.

Instead of keeping stocks that are held at a loss, an investor could turn to ETFs. An investor with, let us say, a loss on healthcare stocks in their portfolio, could sell them off and buy into an ETF sector like iShares DOW Jones U.S. Healthcare Sector ETF.

There are double tax benefits when switching to an EFT from a position of loss on a mutual fund that is actively managed. The first benefit is that of losing on capital without losing the value of the exposure. The second is a more efficient tax position and the added benefit of a limit chance of a distribution of capital gains.