A Complete Guide to US Investment Taxes
Imagine you have saved up some money and decided to invest it to earn additional income. You purchased stocks in a domestic corporation and after some time received a dividend. This extra income you have generated will have tax implications so you now need to know, how are investments taxed (in the US)?
How many types of investment incomes are there?
Suppose you bought a property to sell it at a profit once its value appreciates. Meanwhile, you decide to rent it out to someone. Now you expect to earn income in two ways:
- Rental Income: The monthly rent you receive is your investment income and will be taxed accordingly.
- Gains on the sale of property: The gains you receive once you sell your property is capital gain and will be taxed depending on how long you held the property.
Various factors affect how your investment income is taxed. One of them is the type of investment income. Generally, we can categorize them into the following 4 types.
1. Ordinary investment income:
The rent income you earned by renting out your property is an example of ordinary investment. Interest income is also considered an ordinary investment income.
2. Capital gains
Suppose you sell a property you bought more than a year ago. The proceeds you receive are more than what you paid for it. This means you have a capital gain and you will pay tax on it at long-term capital gain tax rates.
3. Income from tax-deferred investments
You may contribute to retirement plans such as 401(k). You don’t have to pay taxes at the time you make the contributions. This investment will be taxed once you withdraw your earnings from it. These are not tax-free investments. The taxes have just been delayed, therefore it is called tax-deferred investments.
4. Exempt investment income:
You may decide to invest in municipal bonds. Generally, the interest income received on these bonds is exempt from taxes. However, you may have to pay federal taxes on the Interest income generated from US treasury bills and a few other government savings bonds.
How does taxation of investment income work?
Once you make an investment you need to know how are investments taxed (in the US)?
Taxes on dividends
Dividends are the money or stock paid to you by a corporation or mutual funds. Additionally, the distribution you receive from any association, partnership, estate, or trust that is registered as a corporation for tax purposes is also considered a dividend. These can be classified into non-qualified and qualified dividends.
Non-qualified Dividend:
Also called the ordinary dividend, it is the most common type of distribution you receive from a corporation or mutual funds. A rule of thumb is any dividend paid to you is an ordinary dividend unless the paying entities inform you otherwise.
The non-qualified dividend is taxed at the same rate as your income tax.
Qualified Dividend:
If you are a regular investor then at some point you might be notified that you have received a qualified dividend. These are taxed at a lower rate as compared to the non-qualified dividend. Depending on your taxable income and filing status these will be taxed at 0%, 15%, or 20%.
You will only be able to benefit from this preferential tax treatment if the following criteria are met as set out in the publication 550 (2020) Investment income and expenses:
1. Issuance
Qualified dividends can only be issued by a US company or a foreign qualified company. A foreign company is considered qualified if it meets any of the following criteria
- The corporation is incorporated in the US possession.
- The corporation has a tax treaty with the US.
- The stocks of the corporation for which the dividend is paid are readily tradable on an established securities market in the US.
2. Holding period
You have held the share for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of the stock is not entitled to receive the next dividend payment.
3. Specifically listed as non-qualified dividend
Certain dividends are not qualified even if they are termed as one. These include capital gain distribution, dividends paid on deposits with mutual savings banks and similar financial institutions (these are reported as interest income), dividends from a corporation that is a tax-exempt organization during a tax year, etc.
How much you are paid and whether the dividends you received are qualified or non-qualified is indicated on Form 1099-DIV.
Taxes on mutual funds
According to the IRS
“A mutual fund is a regulated investment company that pools funds of investors allowing them to take advantage of a diversity of investments and professional asset management.”
Mutual funds own capital assets such as corporate bonds. shares of stock etc. You own shares in them. They pay you returns either as dividends or capital gains.
When Mutual funds sell the capital assets after holding them for more than a year the income you receive will be capital gain. If the asset sold was held for less than a year then it will be treated as dividend income.
Treat your capital gain income from a mutual fund as capital distribution regardless of the length of time you held the share in mutual funds.
There are instances where mutual funds allow the shareholder to reinvest distribution instead of receiving cash. You still have to report your dividend income even If you utilize your distributions to reinvest.
Taxes on capital gains
You have to pay IRS capital gain taxes on capital assets that you sold at a profit. Capital assets can be property, bonds, stock, or jewelry. The tax rates for these taxes will depend on the length of time you have held those assets.
Capital assets that are held for less than a year are taxed at an ordinary income tax rate whereas those that are held for more than a year are taxed at a capital gain tax rate which is lower than the income tax rate.
How to compute capital gain or losses?
If you sell your capital asset you will either have a gain or loss.
Suppose you purchased a property for $150,000. This cost becomes the initial basis. After a couple of months, you decided to renovate your bedroom for $10,000. Your adjusted basis is now $160,000 (150,000+10,000). The formula for calculating gain or loss is
Capital Gain/loss = Amounts Received - Adjusted basis
If your property is sold for more than the adjusted basis you will have a capital gain. If it sold for less than the adjusted basis you will have a capital loss.
How to use capital losses to reduce your tax liability
The IRS permits capital gains to be offset by capital losses. You can utilize capital losses from Investment A to reduce the gains from Investment B up to $3000 if you are single and $1500 if you’re married and file separate returns. Any unused losses can be carried forward to offset future capital gains.
If you don’t have enough gains to minimize your tax liability you can use capital losses to offset your ordinary income. You can use Schedule D to report your capital gains and losses to the IRS.
To make most of this allowance investors use a tax-loss harvesting strategy to minimize their taxable gains by selling low-performing investments.
To prevent shareholders from claiming artificial capital loss the IRS has a Wash sale rule. If an investor sells the stock and buys a “substantially identical stock within 30 days the capital losses will be disallowed. Moreover, the basis of the identical stock is its cost increased by the disallowed loss.
How Foreign Investment is taxed in the US?
Many investors in the United States invest across the globe to create a more efficient portfolio. Any interest, dividend income, and capital gains earned from foreign investment are subject to US income tax.
You might get taxed in the country where you have invested your money. To minimize this double taxation you might be eligible to get “Foreign tax credit”
According to the IRS
“If you paid or accrued foreign taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes.”
You can either take this tax benefit as a
- Tax Deductions: If taken as a deduction foreign income taxes reduce your taxable income in the United States.
- Tax Credits: If taken as credit, foreign income taxes reduce your tax liability.
The IRS prescribes 4 tests to determine whether a foreign tax qualifies for a credit.
- The tax must be imposed on you
- You must have paid or accrued the tax
- The tax must be legal and actual foreign tax liability
- The tax must be an income tax (or a tax in lieu of an income tax).
How a Foreign Investor is taxed in the US?
The foreign investors are taxed depending on their residential status and the type of investment they hold. A foreigner in the United States can either be classified as a resident alien or a non-resident alien.
A resident alien is a person who was not born in the United States and migrated from a foreign country. He either holds a green card or has passed a substantial presence test.
A non-resident alien on the other hand is an exempt individual such as a teacher or a student who does not hold a green card and has not passed the substantial presence test.
A resident alien is treated as a US citizen for tax purposes. The long-term capital gains are taxed at the lower capital gain tax rate and the short-term capital gains are taxed at their ordinary-income tax rate. They can also use their realized losses to reduce their taxable gain.
A foreigner with non-resident alien status, if not effectively connected with a U.S. business, does not have to file a US tax return. But their income might be taxable in their home country.
They are liable to pay 30% tax on any interest income and dividend they earned through a US company unless there exists a tax treaty between their home country and the US government.
If you have made multiple investments and have a hard time figuring out how are investment taxed (in the US)? And how much exactly do you owe to the tax authority? You can always consult a tax professional.