Investment Tax Planning
Professional advisers recommend that you make investment choices based on factors such as return on investment, level of risk, and portfolio diversification — not on avoiding income taxes. Still, investing your money to gain the best possible return after taxes is a vital part of any investment strategy.
A capital asset is any property you can buy and sell. That includes stocks, bonds, and mutual funds, your home and other real estate, jewelry, cars, and collectibles. A capital gain is the amount of your profit when you sell an asset for more than it cost you. You have a capital loss, on the other hand, if you sell an asset for less than you paid to buy it.
LONG- AND SHORT-TERM GAINS
If you own a capital asset for a year or less before you sell, any appreciation, or increase in value, will give you a short-term capital gain. Short-term gains are taxed as ordinary income, at your regular tax rate.
But if you own certain assets, such as securities, for more than a year before you sell at a profit, you have a long-term capital gain. Generally, those gains are taxed at a maximum rate of 15% if your marginal tax rate is 22% to 35%. If your marginal rate is 10% or 15%, capital gains are taxed at 0%.
However, higher rates do apply for people with higher incomes whose marginal rate is up to 37%. If you file your federal income tax return as a single and have an adjusted gross income (AGI) of $434,550 or higher in 2019, you pay a capital gains tax rate of 20%. If you are married and file a joint return, the 20% rate applies if your AGI is $488,850 or higher.
In addition, if you file as a single and have an AGI of $200,000 or higher, you pay an additional surtax of 3.8% on investment income, including capital gains. If you're married and file a joint return, the 3.8% surtax applies if you have an AGI of $250,000 or higher. In other words, there are actually the equivalent of four possible capital gains rates: 15%, 18.8%, 20%, and 23.8%.
DEDUCTING CAPITAL LOSSES
You can combine your capital gains and capital losses - short-term gains with short-term losses and long-term gains with long-term losses — to offset, or reduce, the gains on which you owe tax. You may even wipe out all your gains and have a net loss.
If you have a net loss, you may also be able to reduce your ordinary income, such as your salary, but there's a cap of $3,000 per year ($1,500 if you're married and filing separate returns). If your capital loss in any year is greater than that amount, you can carry over the excess and deduct it against gains or ordinary income in later years.
HOLDING STOCKS DEFERS CAPITAL GAINS
While you're holding an investment, you don't pay tax on any increase in its value, or what's known as your paper profit or unrealized gain. The market price of a stock you bought for $5 a share may climb to $50, but the tax on that gain is deferred until you sell the stock and collect the proceeds. At that point, your gain is taxed at your capital gains tax rate. Of course, any profit you don't realize could disappear if the market value of the stock or other asset drops.
Passive income or passive losses come from businesses in which you aren't an active participant. These include limited partnerships, rental real estate, and other types of activities that you don't help manage.
Losses from passive investments can be deducted from income you earn on similar ventures. For example, you can use losses from rental real estate to reduce gains on limited partnerships. Or you can deduct those losses from any profits you realize from selling a passive investment. But you can't use passive losses to offset ordinary income or capital gains. The rules governing passive income are complex. You should consult with your own tax adviser about them.