The sale of any non-tax-deferred transactions, known as a capital gain, will cause an impact upon your taxes that must be reported to the I.R.S. The sale of any security (i.e. stocks or mutual funds) or property results in a tax form mailed to you at the end of the year while the sale of most any other transactions (i.e. collectibles, personal property, or possessions) will not result in a tax form mailed to you, unless the sale occurred through a professional organization, at the end of the year.
The sale of real estate property is exempt from taxation except when the sale is not your primary residence. Only the capital gains more than $250,000 when filing single or $500,000 when filing jointly is exempt from income taxes if you lived in the primary residence for 2 of the past 5 years (exceptions exist for changes in health or employment). The sale of any other non-primary residence property is taxable at your current tax bracket. The capital gain received is not required to be applied towards the purchase of another home, regardless if the new home costs less. The sale of real estate property resulting in a loss is also not deductible. Refer to IRS Publication 523: Selling Your Home for more details.
The sale of securities follow different taxation rules because the government wants to encourage the public to invest in their future due to the uncertainty regarding the availability of social security benefits. The increase in the value of an investment sold above the original purchase price is known as a capital gain while the decrease in the value of an investment sold below the original purchase price is known as a capital loss. For instance, if you purchased a mutual fund for $1000, but sold it for $1200, you will pay capital gains taxes on the $200 increase. If the same investment was sold for $800, then you will declare a capital loss on the $200 decrease. Assets owned 12 months or less are considered a short-term investment and will be taxed at your current tax rate. Assets owned more than 12 months are considered a long-term investment and will be taxed at lower rate. For instance, 20% for individuals in the 28% or higher tax bracket or at 10% for individuals in the 15% tax bracket. The tax rate will even reduce further for long-term investments owned for more than 5 years. Therefore, consider the tax consequences when selling securities because you can save yourself hundreds and even thousands of dollars by waiting until you qualify for the lower tax rate. Conversely, a capital loss will allow you opportunity to receive from the I.R.S. a portion of the loss dependant upon your tax bracket. For instance, a $200 loss for an individual in the 28% tax bracket should be able to receive $56 (i.e.: 200 * .28) from their income taxes resulting in a loss of $144 instead of $200. Although, you are limited to declaring a capital loss in a tax year for $1,500 when filing single or $3,000 when filing jointly. The remaining balance can be carried over in subsequent years. You will eventually receiving the tax benefits from the capital loss, but it may take a few years to fully realize that tax benefit.
The taxes associated with the sale of securities can be determined by several methods. The most common of which is the FIFO (first in first out) method. The FIFO method is the default method used by the IRS, but may not be the best method for an investor. The FIFO method indicates the first set of shares purchased will be the first shares sold regardless of when or how many shares were purchased. Another method is to calculate the average cost per share. The average cost is determined by dividing the cost for purchasing all shares by the number of shares purchased (include the capital gain distributions and dividends received) which yields the cost basis per share. The taxes for an investment are determined by subtracting the amount the shares were sold from the cost basis per share.
Another method to minimize your tax consequences when selling securities is to specify the shares to be sold using a technique called lot identification. Lot identification is the identification of a specific number of shares purchased on a specific date. The purpose is to sell the older shares with the intent of minimizing the taxes paid for a capital gain or to sell the shares with the greatest decrease in value with the intent of maximizing the tax deduction for a capital loss. Example: 150 shares of a mutual fund in which 10 shares were purchased each month for the past 15 months. Assuming the investment has increased in value; minimize the tax consequences by selling the oldest of the 150 shares so only a 20% capital gains tax will be paid (assuming the 28% tax bracket) instead of selling the newest of the shares resulting in a 28% capital gains tax to be paid. Assuming the investment has decreased in value; maximize the tax deduction by selling the lowest value of the 150 shares so a 28% capital loss deduction can be declared on a greater amount instead of selling the highest value of the 150 shares to receive a smaller deduction. Also, sell shares that will result in a deduction before selling shares that will result in a capital gain. The idea is to get money back from the IRS, not give them money!
Individuals who trade securities frequently should be aware of the Wash Sale Loss Rule. A violation of the Wash Sale Loss Rule occurs when a security is sold at a loss, with the intention of claiming a capital loss on your income taxes, within 30 days of the purchase of the security or when a security is sold at a loss, then repurchased again within 30 days of selling the security. Therefore, do not conduct a security transaction until the 31st day before or after a transaction upon the same security occurs. Failure to abide by the rule can result is a much further loss in an investment's value because you will not be able to recoup some of your losses when filing your income tax.
Refer to IRS Publication 550 - Investment Income and Expenses for further information.
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