Taxes are a fact of life. Any amount of income you earn is subject to some form of tax. But even as the government takes your money, it also offers some breaks to help you save as much as you can.
Capital gains taxes are important for stock investors to understand. In this post, the experts at Gorilla Trades will explain what they are and how to reduce capital gains tax on stocks.
What Are Capital Gains Taxes?
Every time you sell a stock, you incur a capital transaction. If you sell the stock at a profit, you incur capital gains. The amount of profit you make is taxable.
When you sell a stock for a loss, it’s called a capital loss. The amount of loss can be deducted from your annual income and is therefore non-taxable.
For the purpose of taxation, capital gains or losses are classified into two types: short-term and long-term. If you sell a stock that you’ve held for less than 365 days, you incur a short-term capital gain (or loss). If you sell a stock that you’ve held for longer than a year, it’s a long-term capital gain (or loss).
Short-term and long-term capital gains taxes are rated differently – generally, short-term rates are higher than long-term rates. Many investors strategize buying and selling shares so that their capital losses offset their capital gains, thereby reducing their taxes.
But other methods can help you save money when the IRS comes to collect. Here are some examples of how to pay less taxes on stocks.
How close are you to the upper reaches of your tax bracket? If you’re at the higher end, you might soon advance to the next tax bracket. When that happens, your tax rate will increase.
If you’re at that point, you’ll want to pay close attention to your capital gains. Even though long-term gains come with a lower tax rate, if you realize them, they become part of your adjusted gross income – and that could put you in that higher tax bracket before you want to be there.
One strategy to avoid this scenario is to delay selling your stock until a later time. You could also try to bundle deductions into your current tax year to offset the gains tax, keeping you at the lower rate.
This strategy involves selling some stocks at a loss, strictly to counterbalance capital gains from stocks you sell at a profit. When you unload a stock for a loss, that loss is applied against your capital gains. You’d apply short-term losses to short-term gains and – wait for it – long-term losses to long ones.
If you end up experiencing more capital losses than gains in a given year, you can use up to $3,000 to offset other kinds of taxable income, lowering your rate even more.
You can buy the stock back at a later date, but there’s a catch: When you sell shares in a stock strictly to take the loss, you have to wait 30 days before you buy what the IRS calls “substantially identical” stock shares (i.e., that same stock).
If you sell and buy back within those 30 days, the IRS calls it a “wash sale,” and the transaction can’t be used for tax purposes.
Did you know you can donate stock shares to approved charities? They’re considered as good as straight cash donations. Many stockholders see stock donations as a way to make a positive impact without having to dip into their cash reserves.
Just like cash donations to charity, stock donations are tax-deductible. You simply deduct the value of the shares on the day you donated them from your tax returns (if you’re allowed to itemize your deductions).
Keep in mind the itemized deduction will need to be higher than the current year’s standard deduction for your filing status.
In addition to the tax deduction, you won’t be liable for any of the capital gains on a donated stock if its value increased.
The IRS has instituted a tax break meant to encourage large-scale investment in certain smaller companies valued at less than $50 million immediately after it goes public. These companies are known as qualified small businesses (QSBs).
If you buy shares of a QSB, the IRS allows you to exclude up to $10 million of capital gains from your income. If you hold onto your shares for many years, you may be able to exclude between 50% and 100% of capital gains from your tax bill.
Not all small businesses are eligible for this tax break, so make sure the business you’re interested in qualifies for the QSB deduction. Consult with your tax professional before investing.
In 2017, Congress passed the Tax Cuts and Jobs Act to help revive economically troubled communities. The legislation allows those who reinvest their capital gains in these “opportunity zones” some substantial tax benefits.
Opportunity funds are primarily used to construct housing and businesses in areas that need them the most. If you reinvest your capital gains in real estate or businesses in an opportunity zone, you may be able to defer taxes on these gains until December 31, 2026, or have those taxes reduced.
If you’re looking for a qualified distressed community to invest in, check out the IRS’s page on Opportunity Zones.
Tax-advantaged individual retirement accounts (IRAs) offer investors a great chance to save on taxes while building up their retirement funds. If you use your IRA as the vehicle for your investments, your annual realized capital gains won’t be subject to taxes.
How these tax breaks are applied depends on what type of IRA you have. In a traditional IRA, the gains are added to the account balance with no tax liability. Instead, your distributions from the fund will be taxed after you retire and become eligible to withdraw from the account.
A Roth IRA essentially works the reverse way. Your capital gains and contributions are taxed as you make them. But after you retire, distributions from the fund are tax-free.
Capital gains taxes only come into play when you sell your shares. Therefore, a good way to save on capital gains taxes is to not sell your shares.
Seriously, if you hold onto your shares until your death, you may be able to give your inheritors a tax break, too. This happens with a vehicle called a cost basis step-up.
The cost basis of any investment is how much the investor paid to obtain it. After you die, the cost basis is adjusted to the investment’s value at the time of your death.
This can wipe out most or all of the capital gains taxes that investment would have incurred if you’d sold it. When your heirs choose to sell these shares, they’ll save money – lots of money if it’s a highly valuable stock. It’s a great gift to give, especially from someone who’s dead.
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