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How Do Investments Affect Taxes?

How Do Investments Affect Taxes?
Ines Zemelman, EA
20 June 2022

Investing surplus money is a great way to multiply your wealth and get a sense of financial security. But there are tax implications that you have to consider before making any investment decision. This article discusses how investments affect taxes. 

Read on to find out about capital gains & losses, reporting requirements & strategies to lower your tax bills on stocks.  

What Are Capital Gains & Loses?

Once you decide to invest your money in real estate or stock and bonds you will either receive investment income while you still hold them or you will get a gain when it is sold. 

According to the IRS:

When you sell a capital asset, the difference between the adjusted basis in the asset and the amount you realized from the sale is a capital gain or a capital loss.

Your cost basis is the price you paid when you bought the capital asset. Special rules apply to determine the cost basis when you inherit a property. 

Capital gains can either be short-term or long-term.

  • Short-term capital gains are earned from selling an asset you only held for a year or less. The short-term capital gains are taxed at the same rate as your ordinary income tax rate. You will find that in your income tax bracket
  • Long-term capital gains are earned from selling an asset you held for more than a year. They can be taxed at either 0%, 15%, or 20% depending on your filing status and taxable income. 

How long you hold a capital asset will determine the capital gains tax rates. If you sold a capital asset at a loss you are allowed to offset it against your gains to lower your taxes.

How Do I Know That I Have To Report?

Generally, when you start making money regardless of the means, you need to report that. Whether or not you owe taxes that will depend on the following:

  • Your earnings
  • Your allowable tax deductions to lower your taxable income.
  • Your tax credits to reduce your tax liability

How does investing affect taxes? A tax professional will assist you in figuring it out.

Initially, you will report capital transactions on Form 8948 and then use the information in it to fill in Schedule D. Be careful to note the dates when the capital assets are purchased and sold as it will tell you how long have you held them. 

Capital assets will generate money either by investment income or capital appreciation. You have to report all your earnings. How do investments affect taxes? You need to find it out prior to considering whether to invest in properties, stocks & bonds, collectibles, etc. 

Let’s look at the type of investments that can generate income and gain.

Property

Let’s suppose you bought a home and rented it out to earn rental income. In this scenario how your rental income is taxed will depend on whether it is a short-term rental property or regular rental property. If it is later then it will be taxed as real estate income tax. 

Now imagine you sold your property and earned a gain. How long you have held the property will have an impact on how your gain is taxed.

If you sold your property and you have lived there for at least 2 years during the 5-year period ending on the date of sale you can exclude $250,000 gains ($500,000 on a joint return in most cases.). 

Bear in mind that If you sold another home during the 2-year period then you will not be able to exclude this gain. Additionally, you cannot deduct a loss on the sale of your home. 

Stocks & Bonds 

You need to report any gains you earned when you sell your stocks or bonds on Schedule D. If you earned a gain you will owe taxes. If you had a loss you may write off up to $3000 of the losses incurred. If you sold an investment you will receive Form 1099-B from your broker. Use this form to fill in schedule D. 

If you have purchased securities but haven't sold them then you don't have to pay capital gains tax. 

However, you will have to report any dividends or interest income you receive while holding stocks and bonds. Use Form 1099-Div to report dividends & Form 1099-INT to report interest income. It is noteworthy that qualified dividends get a special tax treatment.

Consider this you are presented with an opportunity to invest either in a stock or bond. Which one would you go for? One of the factors that will influence your decision is the tax implications. 

How To Pay Lower Taxes On Stock? 

How does investing in stocks affect taxes? Are there ways to lower your taxes on stocks? Let's look at some of the strategies to reduce your taxes. 

Invest Wisely To Get A Tax Advantage

You can hold stock in a tax-deferred investment. It is when you don't have to pay taxes right away. This means as long as the money stays invested you owe no taxes but as soon as you withdraw the money the taxes are due. There are some qualified plans & municipal bonds where generally your gains & income are tax free. 

Take for example your contributions to a Roth IRA, which are not eligible for deductions. But when you retire & finally take the money out you neither owe taxes on your contribution nor on any return. 

Consider a scenario where you made contributions in a traditional IRA and used it as a deduction to lower your taxable income & then decided to convert it into a tax free investment which is Roth IRA. In this case, you need to pay taxes on your contributions. 

Hold Investment For A Longer Period

Longer-term gains are taxed at a lower rate. If it aligns with your investment objectives you can hold your investment long enough, at least more than a year, to take advantage of the lower rates.

Use Capital Losses To Offset Your Gains

In case your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income during the tax year is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 16 of Schedule D (Form 1040). 

Applying the matching principle, first deduct short-term losses from short-term capital gains & long-term losses from long-term capital gains. 

Whatever losses remain use that to offset all the capital gains either short or long-term. If you still have excess losses use that to reduce your ordinary income. Carry forward any unused losses to offset future income. 

Collectables

You might have an interest in collectings rare stamps, art or coins, etc. Upon selling them if you have capital gain then those gains are taxed at a higher rate which can be up to 28%.

Virtual currency

When you sell virtual currency like Bitcoin, you must recognize any capital gains or losses on the sale, subject to any limitations on the deductibility of capital losses. 

Be aware of the tax consequence of your investment decisions. Seek advice from a tax professional to understand how investments affect taxes. 

Ines Zemelman, EA
Founder of TFX