Posts made in February, 2019

Wash Sale Rule: What Traders Need to Know

Posted by on Feb 27, 2019 in General, Investing

We should naturally feel happy about having some capital gains. But we don’t. Why?

The government makes us pay tax on our profit. That diminishes the overall return generated on our investment.

If you’re an investor, you’d know that we can claim a capital loss. So, naturally, you’d use capital losses to offset capital gains and effectively reduce your capital gains tax.

That’s right. But the Internal Revenue Service (IRS) is a step ahead of us. They have a very specific regulation on capital losses. They call it the wash-sale rule.

 

Securities and Exchange Commission

Let’s read more about it, shall we?

What is the Wash-Sale Rule?

The wash-sale rule is the time frame of 30 days.

The rule defines wash sale as a sale of a security or stock at a loss and repurchase of a substantially identical security within the 30 days before or after the sale. For that matter, even if your spouse or company buys the same security or stock within that period, it is considered a wash sale.

As per the IRS regulation, you can’t claim a tax deduction for a security sold in a wash sale. It protects against the investor who is trying to claim the benefits of short-term losses.

Let’s give a short practical example here.

Let’s just say an investor bought 100 shares of an ABC Technology Company on 1 December for $100 each when the company was soaring high. But as the future is unpredictable, it wasn’t long before the value of the company started to fall. There were reports of accounting frauds, sales breakdown, and financial crisis within the company. All of these situations made the price drop to $60.

The big shot they were, they realized that if they sold their shares at a loss, they could claim tax deductions. And they were correct. But then, something changed. Their advisor informed that the ABC Company will gain back its original value in the market soon.

So what did they do next? On 20 December, they called up their broker and sold all their shares for a loss. And, it was only two weeks after that they bought back those shares.

It might look like a smart move at first. After all, they did lock their capital loss and then again got hold of the shares. But they forgot the wash-sale rule.

As per the rule, we can’t request a capital loss if we repurchase it within 30 days. Since they made a transaction right after 15 days without waiting for the 30 days’ time to elapse, they were not eligible for tax deduction.

And if that wasn’t enough, they had also paid two commissions – one for selling and another for repurchasing, which didn’t look so attractive either.

How Can a Wash-Sale Rule Affect an Investor?

We know what you’re thinking right now. The investor could have waited for the period of 30 days to expire before repurchasing again. What harm would it probably have done?

Well, yes, they could. But the risk involved here is that there are chances that while waiting on the sidelines for the wash-sale period to get over, the price of the share may go up. And that would mean they would have to repurchase the security at a price much higher than what they had anticipated.

Conclusion

Well, isn’t the wash-sale rule smartly thought out? This could actually prevent an investor from committing frauds by claiming temporary capital losses.

We strongly suggest that always keep in mind the wash-sale rule before deciding to re-buy or sell your security or stock. You might not be able to repurchase the shares in the future at the same or lower price.

 

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How Holding Periods Affect Capital Gains Tax 

Posted by on Feb 21, 2019 in Investing

Whenever we add value to a capital asset, making it worth more than the price we bought it for, we become eligible for capital gains tax. This added value becomes realized when we sell the asset. Capital gains tax can be applied to real estate, stocks, bonds and even licenses.

On the other hand, if we sell something for a price lower than the one we bought it for, we find ourselves in a situation called capital loss. Consequently, we can make up for our capital losses in investment A with our capital gains from investment B and the tax system will adapt for it.

Let’s say that we made a capital gain of 50.000$ and a capital loss of 30.000$ on two different investments. The government will tax us only for the 20.000$ from the net result.

However, always keep in mind that capital gains tax depends on how long we have held on to an asset. This means that the tax rate will not be the same for long-term and short-term investments.

With that in mind, let’s start breaking down the capital gains taxes.

Assets Held Less Than One Year

First of all, we should all know by now that short-term investments are the ones we have invested in for less than a year. All income we receive from these investments will be taxed at a higher rate.

Short-term investments are extremely volatile and risky, not to mention that the transaction fees for individual investors are quite high. In order to reduce the number of these types of investments, the government has decided to tax them on a much higher rate.

In 2018, capital gains tax rates for short-term investments were set at 10%, 12%, 22%, 24%, 32%, 35% and 37%.

However, all assets that we keep at Roth IRA or 401k accounts will not fall under capital gains taxation. As a result, these accounts are very attractive to investors.

Ultimately, we can reduce the capital gains tax amount by waiting for our investments to become long-term. We can also reinvest the money we got from dividends into our underperforming investments.

Assets Held More Than One Year but Less Than Five Years

IRS considers every asset that we hold for more than a year to be a long-term investment. Generally speaking, the highest capital gains tax rate is 15% with three exceptions:

  1. The maximum tax rate for small business stock cannot exceed 28% of the net gain.
  2. Net capital gain from selling collectibles cannot exceed 28%.
  3. Any capital gain from selling real property that falls under section 1250 cannot be taxed over 25%.

The IRS clearly favors long-term investments over short-term ones. This is what makes the investors have a buy-and-hold approach and for a very good reason. Long-term investments help stabilize the country’s economy. If the IRS decides to tax long-term investments at a higher rate, we would have a capital flight on our hands.

Ramifications Of Tax Rates On Your Investment Decisions 

 

Let’s imagine two situations.

Situation 1: Say we fall under the 32% tax bracket and want to invest 120,000. After six months we sell our assets for 190,000$ which means that we have acquired a capital gain of 70,000$ with a 58.33% return. Consequently, we have to pay 24,500$ in taxes and end up with the profit of 45,500$.

Situation 2: If we invest 120,000$ in stocks and sell them in the following year for 180,000$ we end up with a capital gain of 60,000$ and a 50% return. However, this is a long-term investment which means that the capital gain tax rate is only 15%. We pay only 900$ in the name of taxes which makes the profit 51,000$.

In short, even though the capital gain was higher in situation 1, the lower tax rate in situation 2 gave as an extra 5000$ profit.

In Conclusion

We covered all the basics necessary for making a good choice of longevity concerning our investments. The lesson here is that we shouldn’t be hasty while making a choice between short-term and long-term investments.

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