Earning returns is a primary motivation for investing in stocks. Investors may also seek income through dividends, among other goals, but typically buy stocks hoping the value will increase. Early investors in successful businesses can gain substantially by buying stock and selling it when the share price is higher.
Naturally, the federal government (and some states) also want to receive a portion of the gain through an income tax. The difference between what you pay for a stock and what you sell it for is a capital gain. The type of capital gain and the tax rate levied on the amount depends on how long you own the stock.
Suppose you buy 100 XYZ shares for $10 each and keep them for two years. At that time, the shares are worth $20 each, so you sell them all for a profit of $1,000. Since you held the stock for over a year, you will pay capital gains taxes at the lower, long-term rate. If you sold the stock within the first year, you would instead pay short-term capital gains rates, which are equal to your ordinary income tax rate.
In either case, your overall income also influences the amount you pay. Still, long-term capital gains rates are no higher than 20%, while ordinary income and short-term capital gains rates can go as high as 37%.
What happens if I also lose money selling stock?
You incur a capital loss if you sell stock for less than you paid. While no taxes are applied to losses, you can leverage the loss to offset gains. For example, if you lose $1000 on stock A and gain $1000 selling Stock B, the gain and loss balance each other and eliminate the taxes you would owe on the gain.
What if I reinvest the proceeds?
Buying additional stock shares with the proceeds from a stock sale will not eliminate or reduce the need to pay capital gains taxes. However, if you reinvest the gain into a QOF (Qualified Opportunity Fund), you can defer the payment of capital gains taxes while you are invested in the eligible fund. QOF investments are part of the Opportunity Zone program Congress created when it passed the Tax Cuts and Jobs Act in 2017.
The program’s details are complex, and projects are subject to numerous requirements to maintain eligibility. Furthermore, the deferral is set to expire at the end of 2026, at which time investors would owe the deferred taxes.
How do capital gains taxes work with mutual funds?
If you hold shares in a mutual fund, you may owe capital gains taxes when the fund sells its holdings and distributes the return to the investors. In most cases, the investor can keep or reinvest the income in more mutual fund shares. In either case, the investor will owe long-term capital gains taxes on the distribution.
If you sell your mutual fund shares for a profit, you will owe taxes on that gain. The applicable rate depends on how long you have held the mutual fund shares.
Of course, if the mutual fund is held in a qualified retirement account, the participant should not need to pay taxes on this income. Instead, they will pay taxes on withdrawals from the account.
Do I pay taxes if I don’t sell?
You have unrealized gains if you own stock valued at more than your basis. You do not owe taxes on unrealized gains. Instead, you pay taxes when you realize the gains by selling the stock. In some cases, investors may prefer to borrow money using the stock portfolio as collateral rather than obtain cash by selling. The effectiveness of this approach depends in part on the interest rate for the loan. The exception to this scenario is regarding gains generated within your mutual funds holdings, as previously discussed.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
