Long and short of sharing stock gains (or losses) with Uncle Sam
When you decide to cash in some of those high-flying stocks or bonds, don't forget to figure on handing over a portion to Uncle Sam. Just how big a portion is a matter of timing. The Internal Revenue Service has two timing categories: long and short. If you hold on to a stock for more than six months, the IRS gives you a tax break. It labels your investment a ``long-term capital gain (or loss).'' If you buy a stock or bond and sell it in six months or less, that's dubbed a ``short-term capital gain (or loss),'' and the government takes a larger bite out of your profit.
(This rule applies to all securities bought after June 22, 1984. If you purchased a stock before June 23, 1984, you had to have held it more than 12 months for it to be considered a long-term gain.)
So if you want to limit the tax on securities, it's a good idea to keep specific records of your trading activities.
The IRS says the ``holding period'' begins the day after you acquire your stock. If bought on the stock exchange, the day of the trade -- not the settlement date -- is the acquisition day. If the security was purchased on the over-the-counter market, the acquisition date is the day the broker buys the stock, not the date the title is passed.
The holding period ends the day the security is traded or sold. At least, that's the way it works if you lose money. If you make money (a gain) on the sale, the settlement date -- five business days after the trade -- is often used as the end of the holding period.
Once you've pegged your investment as long or short term, then you can get an idea of how much the IRS will pocket. If you've sold more than one stock, then tote up your long-term gains or losses and short-term gains or losses. The difference is taxed as follows:
A net long-term gain allows you to exclude 60 percent of the total, and thus only 40 percent of the profit is taxed.
For example, you buy 100 shares of Tax Schemers Inc., a consulting firm, at a cost of $5,000, including all brokerage fees. More than six months later, you sell your Tax Schemers holdings for $6,000. Your long-term gain is $1,000. You can exclude 60 percent, or $600, from taxes. On the remaining $400, you pay taxes at the ordinary rate. If you're in the top, or 50 percent, income tax bracket, then you would pay $200 in federal taxes on your $1,000 profit.
A net short-term gain is taxed as ordinary income. So if you're in the 50 percent bracket, $500 of a $1,000 short-term profit would go to the IRS.
A net long-term loss reduces taxable income on a 2-to-1 basis. For every $2 lost, your taxable income is cut by $1. So if you lost $1,000 on Tax Schemers, you could subtract $500 from your taxable income.
A net short-term loss reduces taxable income on a 1-to-1 basis. If you lost $1,000 on Tax Schemers, you can take $1,000 off your income to be taxed.
The IRS allows you to use a capital loss to offset as much as $3,000 of your income. Losses over $3,000 may be carried over indefinitely into following years until they're used up.
Some corporations pay their stockholders cash dividends regularly and these sums are taxed as income, with two exceptions: The first $100 is free from federal tax if you file separately, and the first $200 is tax-free if you file jointly, according to Al James Golato at H&R Block.
Interest earned on US Treasury bonds is taxed by the federal government as ordinary income but is not taxed by states. Municipal bonds are generally not taxed by cities, states, or the federal government. When any bond is sold or matures, however, you do pay a tax on the gain or loss.
If you own shares in a mutual fund, you will receive a 1099-B report from the fund, detailing your portion of the capital gains or losses incurred by the fund as a whole. ``They're usually pretty specific about how to treat the gains or losses,'' says Larry Goldstein, a tax manager at Arthur Young & Co., a major accounting firm. ``If not, just call the mutual fund and have them explain. I've done that on occasion.''
If the gains or losses are long term for the fund, and you were in the fund for only one month in 1985, you're still considered by the IRS as having a long-term position. But don't try to sell after holding your shares less than six months, to get a nice fat short-term loss. Since you took the long-term gain, any loss (even one less than six months) is a long-term loss, according to Mr. Goldstein.
The form for computing your capital gains or losses is known as Schedule D, which is a supplement to the 1040 form. If you own individual stocks, your broker should send you a 1099-B report of sales, showing each transaction and the dollar amount plus commissions.
Nonetheless, tax advisers say to keep your own record of purchases (which normally don't appear on the 1099-B). Also, if you have bought several blocks of stock in a particular company at different times, those records will enable you to tell your broker which blocks to sell and which to hold. If you or your broker does not keep track of when the blocks were bought, and you sell them indiscriminately, the IRS assumes the first stocks bought are the first sold.
There are tax reform proposals in Congress that would change the capital-gains tax for this year. The top effective rate is now 20 percent; one bill would raise it to 22 percent. The tendency in Congress appears to be toward reducing the exclusion on long-term capital gains, thus raising the tax. But the outcome is far from certain.