Selling a stock for more than its purchase price can create a taxable capital gain. But the amount of tax owed may depend on how long the investor owned the shares before selling them.
U.S. federal tax rules generally distinguish between short-term and long-term capital gains. The difference can affect an investor's after-tax return and should be considered when planning a sale.
The One-Year Holding Period
A capital asset held for one year or less before sale generally produces a short-term gain or loss. An asset held for more than one year generally produces a long-term gain or loss.
Short-term capital gains are generally taxed at ordinary income-tax rates. Long-term capital gains may qualify for lower federal tax rates, depending on the taxpayer's taxable income and filing status.
The distinction makes the purchase and sale dates important. An investor should not rely on an approximate number of months when calculating the holding period.
A Simple Illustration
Imagine an investor buys shares for $5,000 and later sells them for $6,000. Before considering transaction costs and other adjustments, the gain is $1,000.
If the shares were held for less than or exactly one year, the gain is generally short-term. If they were held for more than one year, it is generally long-term.
The actual tax owed depends on the investor's overall taxable income, filing status, other gains and losses, and applicable tax rules.
Capital Losses Can Also Matter
If an investment is sold for less than its tax basis, the investor may have a capital loss. Capital losses can generally offset capital gains, subject to tax rules.
When capital losses exceed capital gains, individuals may generally deduct up to $3,000 of the excess against ordinary income each year, or $1,500 if married filing separately. Unused capital losses can generally be carried forward to future tax years.
The wash-sale rules can restrict the ability to claim certain losses when an investor sells a security at a loss and acquires substantially identical securities within the applicable period.
Dividends Are a Separate Tax Question
Investors should not confuse capital gains from selling shares with dividends received while holding them. Qualified dividends may receive long-term capital-gain tax rates if the relevant requirements are satisfied, while ordinary dividends are generally taxed at ordinary income rates.
A brokerage statement may report both types of income, and they should be reviewed separately.
Records Make a Difference
Investors should keep trade confirmations and review Form 1099-B from their brokerage. The reported cost basis may need adjustment in certain circumstances, particularly after corporate actions, transfers between brokers or other transactions.
Taxable investment accounts, retirement accounts and other financial products can have different tax treatment. Investors should not assume that the capital-gains rules for a regular brokerage account apply in the same way to a 401(k) or IRA.
The Bottom Line
The length of time an investor owns a stock can affect how a gain is taxed. Understanding the short-term and long-term distinction, tracking cost basis and reviewing brokerage tax forms can help investors estimate the after-tax result of a sale. Tax considerations should be part of a decision, but should not be the only reason to hold an investment that no longer fits an investor's goals.
This article is for informational and educational purposes only and should not be considered personalized financial, investment or tax advice.
