How Are Stock Sales Taxed?
Stock Sales Tax Rate
The goal of investing is to generate a profit by buying a stock at one price and selling at a higher price. Once both of these transactions take place, there will be a tax on the stock sale or purchase. There are different tax rates that apply depending on a few factors, and not knowing this information could come at a large cost when filing your tax return.
I will go though various situations that may occur with your investment portfolio. Even if none of these scenarios have occurred yet to your investments, it is great information to have for when the day comes.
Below, I will answer questions about topics such as the stock sales tax rate, the stock short sale tax treatment, tax rates for selling stock options, and many more.
Short-Term vs. Long-Term Capital Gains
The difference between short- and long-term capital gains will be based on the length of time that the investment is held in a portfolio.
If shares were to be purchased and sold within one year, it would be labelled as a short-term capital gain. The drawback of this is that a higher tax rate will be applied to the capital gain of the transaction, ranging from 10% to 39.6%. The tax rate will depend on the method used to file the tax return and income level. There is more information regarding this further below.
For long-term capital gains, it would be classified as a transaction that takes over a year to take place. This would be the period from the buy order and the sell order taking place. A preferred tax rate would apply, which will range from zero to 20%.
Information Needed for Each Trade
Since short- and long-term capital gains are taxed at different rates, there needs to be some documentation to help determine which tax rate would be applied. The following information would be required:
- The exact date that the purchase was made
- Records of the purchase price (this includes fees and taxes that were paid)
- Records of the exact selling date
- The selling price, including fees and taxes
How Is Capital Gain/Loss Calculated?
This is one of the most important steps because, at the end of the day, you do not want to overpay or underpay the Internal Revenue Service (IRS). Before a tax rate is applied, a calculation is required to determine whether there is a gain or loss from the transaction. Below I will go through a few different scenarios that may apply to you.
There will be times when only one buy and sell order is made on a stock within your investment portfolio. The following table shows an example of how this would be calculated.
|Price||Number of Shares||Total Cost|
|Sale of Entire Position||$25.00||100||$2,500|
With this example, the difference would be taken from the selling price and the purchase price. The capital gain in this example would be $1,500, based on the calculation $2,500 − $1,000 = $1,500.
Not every investment that is owned will have a positive outcome. There will be times that a capital loss occurs. The below table shows an example of this.
|Price||Number of Shares||Total Cost|
|Sale of Entire Position||$75.00||1,000||$75,000|
In this example, there would be a loss of $25,000, based on the calculation $75,000 − $100,000 = −$25,000.
Not every transaction within your portfolio will be as simple as one purchase and one sell order. There may be a time when multiple buy orders will take place.
|Price||Number of Shares||Total Cost|
|Purchase of Additional Shares||$5.00||100||$500|
|Sale of Partial Position||$8.00||150||$1,200|
In this case, there are two calculations that would have to take place. The first would be the average cost of the purchase, which is known as the adjusted-cost base. It would go as follows: ($1,000 + $500) ÷ 200 = $7.50.
Even though the shares initially were purchased at $10.00 per share, the average price was lowered due to the second purchase of the shares.
The second calculation would be to determine the capital gain or loss. In this example, the whole position was not sold; only 150 shares were. The average purchase price of $7.50 would be used to determine the gain or loss. This would result in $1,125, based on the calculation $7.50 × 150 = $1,125, which is the total average price for 150 shares.
The selling price of the shares is $8.00, while the total proceeds would be $1,200, based on $8.00 × 150 = $1,200.
The capital gain in this case would be $25.00, based on $1,200 − $1,175 = $25.00.
What Happens if a Capital Loss Is Incurred?
Not every year will turn out as planned, and there could be a year when a capital loss needs to be accounted for. This would occur if a stock was purchased and then later sold at a lower price.
First off, any capital losses could be used against any capital gains. For example, if two trades were placed, with the first being a $200.00 capital gain and the second being a $1,000 capital loss, the result would be a capital loss of $800. That is based on the calculation $1,000 − $200.00 = $800.00.
The capital loss limit per year is $3,000 (or $1,500 if you are married but filed a separate tax return).
If the capital losses happen to be over the limit, they could be carried over to the following year. The capital loss would be treated as if it occurred during the following year.
Federal Tax Rate for Selling a Stock
To determine the tax rate that would be applied, the first aspect to consider is how you would file your tax return. For example, are you single, married, or head of a household? Your income level is the second factor to determine the tax rate that will be applied. Below is a table outlining all this information.
|Single Reported Taxable Income||Married Filing or Qualifying Widow(er)||Married Filing Separately||Head of Household||Tax on Long-Term Capital Gains||Tax on Short-Term Capital Gains|
|$415,051 or more||$466,951 or more||$233,476 or More||$441,001 or more||20%||39.6%|
How Are Stock Dividends Taxed?
Most the time, a company will reward its shareholders with a cash dividend payment. Some companies want to reward their shareholders without affecting their cash positions. The method that is used is to give them a stock dividend. More shares are given of a company that is already owned.
Another reason why some management teams use the stock dividend method is that it gives the investor control of its tax liabilities. Taxes do not have to be accounted for until the shares are sold by the investor.
This is how it works: let’s say you own 1,000 shares of company ABC and a stock dividend of 15% was just announced. This would result in you receiving 15% more shares. A total of 150 (based on 1,000 × 15% = 150) shares would be added to your holding. The new position would represent 1,150 total shares.
When a stock dividend is issued, it is considered a purchase of a stock. If the shares were deposed within a year, it would be considered a short-term capital gain and a higher tax rate would be applied. If the shares were held for more than a year, a lower tax rate would be applied under the long-term capital gain category. Owning the shares for a very long time not only gives you a lower preferred tax rate, but also defers when taxes are owed.
Stock Short Sales Tax Treatment
Short selling is the sale of a security that is not owned by the seller. The seller borrows the security from the broker. The goal of the investor is to profit from a decline in the price of the security.
In plain English, a stock is sold first at a specific price and purchased back at a lower price. The buying and selling of the stock is done in the reverse method that is commonly known.
This investment strategy is used for speculation of an investment or to hedge a position within an investment portfolio. It is also used on investments that are considered overpriced. The risk level is quite high, and this method is used by experienced traders or investors.
The following table gives an example of how to calculate a capital gain or loss on a short sale and how to determine whether a short-term or long-term capital gain/loss tax rate would be applied.
|Price||Number of Shares||Total Cost|
|Borrowing the Stock from the Broker (February 1, 2016)||$10.00||1000||$10,000|
|Buying the Position (March 1, 2017)||$6.00||1000||$6,000|
In this example, the stock is sold for a total of $10,000 and bought for a total of $6,000. The total capital gains in this case would be $4,000, based on the calculation $10,000 − $6,000= $4,000. The position was held for a total of 13 months. The position was purchased on March 1, 2017 and closed out the same day. This means that when everything is said and done, the investor owns or is short zero shares.
In this example, the taxes would be identified as short-term capital gains. Even though the position was held for 13 months, the focus by the IRS is when the position was purchased and closed out. In this case, the holding period was less than one day, which resulted in a short-term capital gain.
Therefore, by using a short-selling strategy, a higher tax rate would be applied, which is the short-term capital gain rate. The tax rate range would be 10% to 39.6%. This is outlined in an earlier chart, under the section heading “Federal Tax Rate for Selling a Stock.”
Stock Options Tax Treatment
A stock option is a financial derivative that is represented in a contract between two parties. The contract offers the buyer the right—but not the obligation—to buy or sell a security. The agreed price is known as the strike price and the period end date is known as the exercise date.
Breaking down options can be done in two subcategories: a call option or a put option. A call option would be purchased if an investor believes that a stock’s price will increase over time. A put option is the opposite; an investor believes there will be a decrease in the stock price. Both of these examples would make you the holder of the option.
There are also opportunities in the marketplace to generate an income by being a writer of an option. A writer of a call option believes that the stock will decrease over a certain time period, and is looking to benefit from this. A writer of a put option would want to see the stock price increase, and income would be earned in the process. This income-generating method would be used if the underlying stock is owned or looking to be owned.
The below table shows information regarding how a call option would be treated in regards to taxes.
|When a Call Option:||Holder of the Option||Writer of the Option|
|Position is Bought Back||Doesn’t have to do anything||Reports a short-term gain or loss|
|Is Sold by the Holder||Reports a capital gain or loss||Sees no effect.|
|Is Exercised||Adds the cost to the cost basis of the underlying stock||Increases the stock cost basis by the income received|
|Expires||Reports a Capital gain or loss||Reports a short-term gain or loss|
The below table shows the tax treatment of a put option. There is information on how the cost basis of a stock should be affected if a stock is already owned.
|When a Put Option:||Holder of the Option||Writer of The Option|
|Position is Bought Back||Doesn’t have to do anything||Short-term capital gain based on the income received and the buy back price.|
|Is Sold By the Holder||Reports the difference in price of the buy and sell as a capital gain or loss.||No effect.|
|Is Exercised||Reduces the cost basis of the underlying stock||Income will reduce cost basis of underlying stock by the amount received.|
|Expires||Reports the cost as a capital loss on the date of expiration||Income would be reported as a short-term capital gain|
Final Thoughts on Stock Sales Tax
The U.S. government encourages investors to think about investing from a long-term perspective. This is why a lower tax rate is applied when an investment is held longer. When it comes to taxes, it is one criteria that should be looked at from an investor’s point of view. However, investment decisions should not be based solely on the taxes. I mean, do not hold on to a stock just because a lower tax rate would be applied, and then sell it once that time period is met.
Hold the investment because of the company’s profit, the shareholder-friendliness of the management team, and the future business potential. If you want to earn an income, only focus on companies that pay dividends to their shareholders. Also, ensure that the risk level of the investment is appropriate for your investment goals and expected returns.