Tax season is upon us and as every good accountant should, we are here to remind you about investment taxes. It is a wonderful day when your investment delivers a high reward, but remember any profit you make is subject to tax. Here is a review of a variety of investment tax treatments for individuals and businesses.
In this article:
- What is capital gains income?
- Types of capital assets subject to capital gains taxes
- Long-term vs short-term capital gains tax rates
- What is a section 1031 like-kind exchange?
- Business investment taxes
- Tax on dividends
- Business property taxes: Section 1231, 1245, and 1250
What Is Capital Gains Income?
For tax purposes, income is broken down into two categories: ordinary income and capital gains income. Ordinary income is what you earn from an individual or organization. Capital gains income is when you sell an asset for more than the purchase price. They each are taxed differently, for this article we will focus on the investment taxes on capital gains income.
Different Types Of Capital Assets
When you sell capital assets you are taxed on the income you gain or lose. What types of assets qualify as capital gains income? Here is a brief list of different types of capital assets:
- Cars, machinery, boats, jewelry, collectibles, and other tangible items
- Real Estate (excluding your primary home)
Capital Gains Taxes
Any income earned from the sale of your investment is subject to capital gains taxes. You report capital gains or losses on a Schedule D. How your capital gains are taxed is dependent on a couple of factors.
Realized vs Unrealized Capital Gain
A realized capital gain/loss happens when you cash out on your investment. An unrealized capital gain/loss occurs while stock is held, it is a glorified mental note since the investment hasn’t been sold. You are only taxed on realized gains/losses; you do NOT have to report unrealized capital gains.
Reporting Unrealized Investment Gains
Even though individuals don’t need to report unrealized gains or losses, some organizations will. Publicly traded companies following GAAP standards will report unrealized gains and losses on their quarterly earnings reports. However, they are not taxed until the investment is sold, and generally do not pass unrealized gains to company owners. This is solely for display purposes, to show their background financial activity.
Mark-to-Market 475 (f) Election
The only time unrealized capital gains are taxed is in a Mark-to-Market 475 (f) election. This election applies to only qualified investors like dealers and high-volume traders, who invest for business.
Dealer: a person trading in securities who regularly buy large volumes of securities and sell them to customers.
Trader: individuals who engage in high volume trading stock for their own benefit, can deduct ordinary and necessary expenses against their investments.
Investor: engages trading activity buying and selling at low volumes for personal gain. Cannot make a mark-to-market election.
At the end of the year, if any investments have an unrealized gain/loss, the business will make this election and depending on the business structure, pass through gains or losses to owners. Why make a Mark-to-Market election? It allows investment income to be taxed more advantageously at ordinary income tax rates versus capital gains tax.
Long-term vs Short-term Gains
There are two types of gains: short-term and long-term. This is your holding period, or how long you kept the investment. Short-term investments are sold within a year. Short-term capital income tax rates depend on your income bracket and are assessed at income tax rates, ranging from 10-30%.
Long-term gains are held for more than a year. The IRS incentivizes investors to participate in the market, by offering reduced tax rates for long-term gains. Long-term capital income tax rates also follow income tax brackets but are assessed with a discounted tax rate, ranging from 0-20%. See the breakdown of long-term capital gains tax rates for 2021 below:
For Example: you sell some stock for $3000 in 2021. You are married filing jointly, the sum of your taxable income, including your stock earnings, is below $83,350. So you won’t be taxed on your capital gains.
An additional net investment income tax of 3.8% can be applied in some instances. Net investment income tax usually is reserved for high-income earners with large investments. Unlike capital gains taxes, the additional net investment income tax is based on your modified adjusted gross income, different from taxable income. Modified adjusted gross income tax thresholds range from $125K-250K, depending on filing status.
What Age Are You Exempt From Capital Gains Tax?
Unfortunately, there is no AARP with capital gains tax. NO age exempts you from paying investment taxes. There was an exemption in the past that applied to capital gains on a property for people 55 or above but this is no longer valid.
Capital Gains Income Tax Reporting
When reporting your investments you will classify them into one of three categories: a gain, loss, or wash. How it is classified will also determine how you are taxed. See the difference between the 3 categories of capital asset sales below:
Capital Gains: when you make money off a sale.
Losses: when you lose money on a sale.
Wash Sale: there was no gain/loss.
Taking A Loss
Taking a loss happens when you sell your investment for less than the original price. Losses aren’t worthless, they can be reported on taxes and used to counter capital gains. Even more, a short-term loss on an investment sold within a year can offset capital gains entirely, and any excess can chip away at ordinary income. Are you a prognostic gambler? Then sell losing stock within a year rather than hold out, taking a loss will be more beneficial on your investment taxes.
Note: you are limited on how much of your excess capital loss can be deducted from ordinary income.
Resulting In A Wash
The wash sale rule is for short-term concurrent sales that equal no capital gain/loss. What does that mean? This is when you purchase stock and sell it shortly after. Then you repurchase that same stock within a short window of time.
For Example: If you buy Apple stock on the first of the month, on the 15th you are losing money so you sell it. If you repurchase the same amount of Apple stock at the end of the month, it is considered a wash.
A wash sale is never considered long-term. It should only be claimed for trading activity happening within 60 days. The IRS implemented this rule to combat loss harvesting, which reduces capital gains tax.
Schedule D Form 8949
When you are reporting gains, losses, and wash sales, you will do so on Schedule D Form 8949. Generally, investors will receive a 1099-B that organizes their trading activity in a cohesive form for filing. When filling out Form 8949, follow your 1099-B precisely, your taxes need to match what has been reported to the government by your investment broker or trading platform.
See the Form 8949 example below:
What Is Section 1031 Like-Kind Exchange?
There is a way to defer capital gains taxes on investment or business property. You can reinvest your capital gains into another investment, in a Section 1031 like-kind exchange. Plus your gains can be rolled over infinitely from one investment to another, including depreciation. There are a couple of rules investors must conform to when using a Section 1031 like-kind exchange.
- Real Property: you can only exchange real property, this excludes personal property like a home and intangible property like a patent.
- Time Limit: there is a 45-day window for buying or selling the first property, a 180-day closing window for the second property.
- Like-Kind: the reinvestment exchange has to be similar, ex: a business for a business, or land for land.
- No Cash Handling: Once you sell your investment an intermediary needs to handle the money.
- Extra Cash Boot: Any extra cash (bootie) from the sale will be given to you after the 180-day window by the intermediary and subject to capital gains tax.
Section 1031 Example: you invest in a Pizza Shop and after 3 years sell it to buy a Car Wash. You sell the Pizza Shop but do not close on the Car Wash for another month. The money you earned from the sale is held by your broker, who will pay for the Car Wash on your behalf. Once you close on the Car Wash any capital gains plus depreciation are deferred until you sell.
Business Investment Taxes
On the other end of the investment tax spectrum are companies. Businesses filing earnings on investments, and distributing profits to their investors, have specific tax requirements. Here are the broad strokes of applying the proper tax treatment.
Tax On Dividends
At the end of the year, corporations are taxed on dividends. When you buy stock in a company, owners receive dividend distributions of profits earned by a company. These dividends are NOT tax-free for a C Corp, they must pay taxes on earnings quarterly. Then dividends are taxed again when shareholders report them on personal tax returns.
For businesses structured as a C Corporation dividend distributions are reported to investors on a 1099-DIV. How owners will be taxed on dividends at the end of the year, depends on whether the business is paying out qualified dividends. This needs to be determined and noted on the 1099-DIV in box 1a Ordinary, or 1b Qualified.
Qualified Dividend: is eligible for a lower capital gains tax rate.
Ordinary or Non-Qualified Dividend: taxed at the investor’s ordinary income tax rate.
What counts as a qualified dividend? Most long-term stock dividends going to investors are considered qualified. These are 2 rules that businesses must consider before a dividend distribution:
- The dividend is being paid by a U.S.-based or qualifying foreign corporation.
- The recipient of the dividend has held the common stock in the company for 121-days, or preferred stock for 181-days.
Once a shareholder sells their stock, any remaining stock held is still eligible for the original holding period starting at the purchase date. The sold stock has exited the holding period. So a shareholder could potentially receive both qualified and ordinary dividends on their 1099-DIV.
Qualified Dividends Example
A shareholder purchased 100 shares in your company on January 1st. They sell 20 shares before the end of January and they maintain 80 shares through the end of the year. When you go to issue 1099-DIV, you will categorize 20 shares as ordinary dividends because they were sold within the 121-day window, and 80 shares as qualified dividends.
Business Property Investment Taxes
When a business sells real estate, distinguishing between what is taxed at ordinary income vs capital gains income, makes or breaks the bank. Due to liability that tax software companies take on, for filing on your behalf, they will lump your business property gains into one category, preventing any potential errors from the IRS.
However, when you miscategorize an asset as capital gains income you are potentially increasing investment taxes. That’s why knowing how to file will help you reduce your bill and avoid unnecessary tax payments. Three tax treatments can specifically apply to business property assets.
What Is Section 1231 Property?
Section 1231 property is real or depreciable property held for longer than a year. This is a property like buildings, machinery, land, leases, natural resources, and other tangible items. It does NOT include inventory or intangible property like patents and licenses. When you receive a capital gain from a 1231 property then you are subject to capital gains tax, when you take a loss you can take an ordinary income loss. This taxation is true unless you can recapture some depreciation, a subject debatable in Section 1245 vs Section 1250.
Section 1245 vs Section 1250 Property
Section 1245 vs Section 1250 property both deal with depreciation. Since property suffers wear and tear, over time investors can redeem those expenses by deducting depreciation. When an investor or business sells the property, depreciation expenses are excluded from the property valuation because the IRS doesn’t want you to double-dip.
For Example: An office building cost $1.5M but you paid $500,000 in depreciation during the time that you held the property. You decide to sell the property, for $3.5M however the value you report on taxes is reduced by depreciation so it is $3M
Section 1245 assets are depreciable property like furniture and equipment, minus buildings and structural components. As well as amortized intangible assets like patents and intellectual property. When a property is deemed Section 1245 then it is taxed favorably like a Section 1231— long-term capital gains tax rate for profit, an ordinary income tax rate for loss.
Section 1250 assets are real property, like land, buildings, and leases. For these assets when you sell them you cannot recapture your depreciation expenses as ordinary income. This is because you already claimed an ordinary income deduction when you expense depreciation during the time you held the property. When you sell a Section 1250 property if you were taxed with a long-term capital gains tax on your earnings you ultimately would be taxed less on the property than you should have.
At-risk Investment Definition
Businesses need to pay attention to how they are gambling with investor equity. When a company decides to move in a certain investment direction they should determine the appropriate risk involved, and report the calculated risk to investors.
If a business owner realizes a capital loss on an asset they could qualify for at-risk rules. They are allowed to deduct a certain amount of loss depending on the risk. Generally, assets that have a guaranteed return for the business, do not pose a risk and therefore at-risk rules are NOT applicable. However if the sale of your depreciable property results in a Section 1245, you need to check whether you qualify as an at-risk investment.
Investment Taxes For The Savvy Player
There is no way around investment taxes. Whether you are investing on an individual level or at the business level, you need to file your gains/losses on your taxes. We highly recommend consulting with a tax professional when filing investments. Especially if you are a high-income earner, corporation, or high-volume investor. Tax software is not as savvy at deploying tax strategies as well as a human in this arena.