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Capital gains taxes

Lesson in Course: Investing basics (advanced, 4min)

We are expected to pay taxes when we make money. What does that mean when we make money from investing?

Eureka!

What it's about: Successful investing means we'll make money.

Why it's important: We owe taxes on the money we make from investing.

Key takeaway: We owe less taxes when we hold onto investments for the long term.

Opening up our portfolio and seeing a lot of green can feel like this:

However, we have to consider taxes before we start swimming in cash.

When are we taxed?

All capital gains have the potential of being taxed.

What is Capital gain?

When our investment has gone up in value from when we bought it.

However, not all capital gains are taxed every year. Unrealized gains are exempted from taxes until the asset is sold.

What is Unrealized gain ?

The potential profit or loss that is "on paper" in our account. It becomes realized once we sell the investment.

Unrealized gains are also called paper gains due to the marked increases in an account statement (on paper) at the end of every month. Unrealized gains are not taxed because we can lose our unrealized gains if the market goes down. 

Loss of unrealized gains

For example, let's assume we bought a share of $AAPL at $300 per share, and the current market value is $360 per share. At this point, we have $60 in unrealized gains. But, we would lose all of our gains if $AAPL drops to $290 per share tomorrow.

On the other hand, realized gains are the locked-in earnings after we sell an investment. Thus, all realized gains from the sale of investments, stocks, or property are taxed. 

Taxes are owed when we realize gains on our investments
What is Realized gain ?

The profit or loss we made when we've sold our investment

Following the same example above, once we sell our $AAPL share for $360, the $60 becomes realized and taxable. If we had ten shares, we would have a taxable gain of $600.

 

Different tax rates

Short and long term gains are taxed at a different rate

The tax rate used to calculate what we owe from selling depends on how long we've held the investment. It can be either short-term capital gains (STCG) or long-term capital gains (LTCG). LTCG is preferred over STCG since the tax rate is lower.

What is Short-term capital gain ?

When we've sold an investment within one year of buying it. The gains are taxed as normal income

If we bought our ten shares of AAPL on January 1, 2020, and sell the shares on December 28, 2020, the $600 gain will be taxed as ordinary income. The tax rate, in this case, depends on where we fall in the federal income tax bracket.

Example 2020 federal income tax brackets
What is Long-term capital gain ?

When we've sold an investment more than one year of buying it. The gains are taxed at a lower rate than short-term capital gains

For most, LTCG is taxed at 15%. However, depending on how much money we make, it could be either 0%, 15%, or 20%.

If we bought our ten shares of $AAPL on January 1, 2020, we would have to wait until at least January 2, 2021, before selling to qualify for a better tax rate.

Example 2020 LTCG rates
 

Repeat purchases and sales

Things get complicated when shares are purchased and sold multiple times. Each purchase will have a cost basis and a purchase date and taxes will be calculated with the cost and date for specific shares.

Tax lots can be challenging to track if we trade frequently
Example of repeat purchases
  1. We purchased one share of AAPL in January 2019 at $300 a share.
  2. We buy one more share of AAPL in March 2019 at $320 a share.
  3. We sell two shares of AAPL in February 2020 at $380 a share.
  4. Stock dips, and we buy two shares of AAPL three months later in May 2020 at $360 a share.
  5. Currently, shares are trading at $400 a share.

When we sold two shares of AAPL in February, only one of our shares, purchased in January 2019, qualified for LTCG treatment. The other share still falls under the STCG tax ruling. So the taxes we owe are $80 in LTCG and $60 in STCG. At the same time, we are also sitting on $40 worth of unrealized gains from the repurchases. So when we sell those shares, we could add to our STCG taxes owed for the year.

Note, for the scope of this lesson, we only covered capital gains and tax liabilities owed. Capital losses can also be realized or unrealized in the same manner as capital gains and can be used to deduct from tax liabilities for the year. One thing we need to be on the lookout for is the wash sale rule.

 

Actionable ideas

Optimized tax strategies work best when you have an accountant we can trust to help us plan. Unfortunately, keeping track of capital gains and losses is very difficult and time-intensive. Hiring professional help is a good idea here. You can also limit how much you pay in taxes by holding onto investments for the long term before realizing the capital gains.

 

Supplementary materials

Here is a short video reviewing capital gains taxes
https://www.youtube.com/watch?v=-npvWSI_wP8&ab_channel=1031Gateway

Glossary

What is Capital gain?

When our investment has gone up in value from when we bought it

What is Realized gain ?

The profit or loss we made when we've sold our investment

What is Unrealized gain ?

The profit or loss that is "on paper" in our account. It becomes realized once we sell the investment.

What is Short-term capital gain ?

When we've sold an investment within one year of buying it. The gains are taxed as normal income

What is Long-term capital gain ?

When we've sold an investment more than one year of buying it. The gains are taxed at a lower rate than short-term capital gains