Tax treatment for investments varies dramatically based on factors such as type of investment, type of income it produces, how long you’ve held it and whether any special limitations or breaks apply. On top of that, economic uncertainty has made tax planning for investments especially challenging this year.
And there are many additional factors to evaluate before deciding whether to sell or hold an investment, such as investment goals, time horizon, risk tolerance, factors related to the investment itself, fees and charges that apply to buying and selling securities, and your need for cash. But taxes are still important to consider.
Capital gains tax and timing
Although time, not timing, is generally the key to long-term investment success, timing can have a dramatic impact on the tax consequences of investment activities. Your marginal long-term capital gains rate can be as much as 20 percentage points lower than your ordinary-income tax rate.
The long-term capital gains rate applies to investments held for more than 12 months. The applicable rate depends on your income level and the type of asset you’ve sold. See information shared at “What’s the maximum 2020 capital gains tax rate.”
Because of TCJA-related changes to the brackets, through 2025, the top long-term gains rate of 20% kicks in before the top ordinary-income rate does. Higher rates still apply to certain types of assets.
Holding on to an investment until you’ve owned it more than one year may help substantially cut tax on any gain. Keeping it even longer can also make tax sense.
Being tax-smart with losses
Losses aren’t truly losses until they’re realized — that is, generally until you sell the investment for less than what you paid for it. So while it’s distressing to see an account statement that shows a large loss, the loss won’t affect your current tax situation as long as you still own the investment.
Realized capital losses are netted against realized capital gains to determine capital gains tax liability. If net losses exceed net gains, you can deduct only $3,000 ($1,500 for married taxpayers filing separately) of losses per year.
against ordinary income (such as wages, self-employment and business income, interest, dividends, and taxable retirement plan distributions). But you can carry forward excess losses until death.
If you don’t have enough gains to absorb losses, you could be left with losses in excess of the annual ordinary-income deduction limit. So think twice before selling an investment at a loss. After all, if you hold on to the investment, it may recover the lost value. In fact, a buy-and-hold strategy works well for many long-term investors because it can minimize the effects of market volatility.
Of course, an investment might continue to lose value. That’s one reason why tax considerations shouldn’t be the primary driver of investment decisions. If you’re ready to divest yourself of a poorly performing stock because, for example, you don’t think its performance will improve or your investment objective or risk tolerance has changed, don’t hesitate solely for tax reasons.
Plus, building up losses for future use could be beneficial. This may be especially true if you have a large investment portfolio, real estate holdings or a closely held business that might generate substantial future gains, or if tax rates increase.
Finally, remember that capital gains distributions from mutual funds can also absorb capital losses.
Wash sale rule
If you want to achieve a tax loss with minimal change in your portfolio’s asset allocation, consider the wash sale rule. It prevents you from taking a loss on a security if you buy a substantially identical security (or an option to buy such a security) within 30 days before or after you sell the security that created the loss. You can recognize the loss only when you sell the replacement security.
Fortunately, there are ways to avoid triggering the wash sale rule and still achieve your goals. For example, you can:
- Sell the security and immediately buy securities of a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold,
- Sell the security and wait 31 days to repurchase the same security, or
- Before selling the security, purchase additional shares of that security equal to the number you want to sell at a loss, and then wait 31 days to sell the original portion.
Alternatively, you can do a bond swap, where you sell a bond, take a loss and then immediately buy another bond of similar quality and duration from a different issuer. Generally, the wash sale rule doesn’t apply because the bonds aren’t considered substantially identical. Thus, you can achieve a tax loss with virtually no change in economic position.
Warning: You can’t avoid the wash sale rule by selling stock at a loss in a taxable account and purchasing the same stock within 30 days in a tax-advantaged retirement account.
Investing in mutual funds is an easy way to diversify your portfolio. But beware of the tax pitfalls.
First, mutual funds with high turnover rates can create income that’s taxed at ordinary-income rates. Choosing funds that provide primarily long-term gains can save you more tax dollars because of the lower long-term rates.
Second, earnings on mutual funds are typically reinvested. Unless you or your investment advisor increases your basis accordingly, you may report more gain than required when you sell the fund. Brokerage firms are required to track (and report to the IRS) your cost basis in mutual funds acquired during the tax year.
Third, buying equity mutual fund shares late in the year can be costly taxwise. Such funds often declare a large capital gains distribution at year end, which is a taxable event. If you own the shares on the distribution’s record date, you’ll receive and be taxed on the full distribution amount even if it includes significant gains realized by the fund before you owned the shares. And you’ll pay tax on those gains in the current year — even if you reinvest the distribution.
Small business stock
By purchasing stock in certain small businesses, you can diversify your portfolio. You also may enjoy preferential tax treatment:
Conversion of capital loss to ordinary loss. If you sell qualifying Section 1244 small business stock at a loss, you can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary, rather than a capital, loss — regardless of your holding period. This means you can use it to offset ordinary income, reducing your tax by as much as 37% of this portion of the loss. Sec. 1244 applies only if total capital invested isn’t more than $1 million.
Tax-free gain rollovers. If within 60 days of selling qualified small business (QSB) stock you buy other QSB stock with the proceeds, you can defer the tax on your gain until you dispose of the new stock. The rolled-over gain reduces your basis in the new stock. For determining long-term capital gains treatment, the new stock’s holding period includes the holding period of the stock you sold. To be a QSB, a business must be engaged in an active trade or business and must not have assets that exceed $50 million, among other requirements.
Exclusion of gain. Generally, tax- payers selling QSB stock are allowed to exclude up to 100% of their gain if they’ve held the stock for more than five years. But, depending on the acquisition date, the exclusion may be less: The exclusion is 75% for stock acquired on or after Feb. 18, 2009, and before Sept. 28, 2010, and 50% for stock acquired before Feb. 18, 2009.
When the exclusion is less than 100%, the taxable portion of any QSB gain will be subject to the lesser of your ordinary-income rate or 28%, rather than the normal long-term gains rate. (See Chart 3 on page 8.) Thus, if the 28% rate and the 50% exclusion apply, the effective rate on the QSB gain will be 14% (28% × 50%).
Keep in mind that all three of these tax benefits are subject to additional requirements and limits. Consult your IMC tax professional to be sure an investment in small business stock is right for you.
If you’ve invested in a trade or business in which you don’t materially participate and where income or loss flows through to your tax return, remember the passive activity rules. Why? Passive activity income may be subject to the 3.8% NIIT, and passive activity losses generally are deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limits.
To avoid passive activity treatment, you must “materially participate” in the activity, which typically means you must participate in the trade or business more than 500 hours during the year or demonstrate that your involvement constitutes substantially all of the participation in the activity. But there are other ways to meet the material participation test. Plus, there are special rules that apply to real estate. To help ensure your hours claim will be able to withstand IRS scrutiny, carefully track and document your time. Contemporaneous recordkeeping is better than records that are created after the fact.
If you don’t pass the material participation test, consider:
Increasing your involvement. If you can exceed 500 hours, the activity no longer will be subject to passive activity rules.
Grouping activities. You may be able to group certain activities together to be treated as one activity for tax purposes and exceed the 500-hour threshold. But the rules are complex, and there are potential downsides to consider.
Looking at other activities. If you have passive losses, one option is to limit your participation in another activity that’s generating income, so that you don’t meet the 500-hour test. Another is to invest in an additional income-producing trade or business that will be passive to you. Under both strategies, you’ll have passive income that can absorb some or all of your passive losses.
Disposing of the activity. This generally allows you to deduct all passive losses — including any loss on disposition (subject to basis and capital loss limitations). But, again, the rules are complex.
Even if you do pass the material participation test, be aware that your loss deduction might be affected by the TCJA’s rules for deducting business losses.
Qualified dividends are taxed at the favorable long-term capital gains tax rate rather than at your higher ordinary-income tax rate. Interest income, however, generally is taxed at ordinary-income rates.
So stocks that pay qualified dividends may be more attractive taxwise than other income investments, such as CDs and taxable bonds. But there are exceptions.
Some dividends, for example, are subject to ordinary-income rates. These include certain dividends from:
- Real estate investment trusts (REITs),
- Regulated investment companies (RICs),
- Money market mutual funds, and
- Certain foreign investments.
The tax treatment of bond income varies. For example:
- Corporate bond interest is fully taxable for federal and state purposes.
- Bonds (except U.S. savings bonds) with original issue discount (OID) build up “interest” as they rise toward maturity. You’re generally considered to earn a portion of that interest annually — even though the bonds don’t pay this interest annually — and you must pay tax on it.
- Interest on U.S. government bonds is taxable on federal returns but exempt by federal law on state and local returns.
- Interest on state and local government bonds is excludable on federal returns. If the bonds were issued in your home state, interest also may be excludable on your state return, depending on the state.
The fact that a bond is exempt from federal tax doesn’t necessarily make it a better choice than a comparable taxable bond. Municipal bonds, for example, typically offer lower yields than comparable corporate bonds. To make a fair comparison, you need to calculate the tax-equivalent yield — which incorporates tax savings into the municipal bond’s yield — using this formula:
Tax-equivalent yield = actual yield / (1 – your marginal tax rate).
But you also need to consider factors such as risk and how well each bond will help achieve your overall invest- ment goals.
Warning: Tax-exempt interest from private-activity municipal bonds can trigger or increase AMT liability. However, any income from tax-exempt bonds issued in 2009 and 2010 (along with 2009 and 2010 re-fundings of bonds issued after Dec. 31, 2003, and before Jan. 1, 2009) is excluded from the AMT. And AMT is less of a risk for most taxpayers now.
Taxpayers with modified adjusted gross income (MAGI) over $200,000 ($250,000 if married filing jointly and $125,000 if married filing separately) may owe the net investment income tax (NIIT) on top of whatever other tax they owe on their investment income. The NIIT equals 3.8% of the lesser of net investment income or the amount by which MAGI exceeds the applicable threshold.
Net investment income can include capital gains, dividends, interest, passive business income, rental income and other investment-related income. But it doesn’t include business or self-rental income from an active trade or business.
Many of the strategies that can help you save or defer income tax on your investments can also help you avoid or defer NIIT liability. And because the threshold for the NIIT is based on MAGI, strategies that reduce your MAGI — such as making retirement plan contributions — could also help you avoid or reduce NIIT liability.