Tax time can be stressful because you have to gather dozens of documents and invest time to file your tax return.
Preparing your tax return with errors or missing documentation costs time and a great deal of money you can’t afford to spend. Worst of all, tax laws change constantly, making tax preparation that much harder.
One of the most misunderstood areas of tax is the taxation of investment income and capital gains. If you need to understand how investments are taxed and how to file an accurate tax return, read on…
1. How interest income and dividends are taxed
Many taxpayers earn interest income on bank accounts or bond investments, and some receive dividend income on stocks they own.
If you have interest and dividend income, the institution paying the income must provide a Form 1099-B, and the amounts are posted to Schedule B on your personal tax return.
Some forms of interest and dividend income are non-taxable, such as interest earned on certain types of municipal bonds. Form 1099-B will document the income you receive, and the amounts that are taxable and non-taxable.
If the total taxable income is less than $1,500, you report the earnings, but you don’t need to complete Schedule B.
Taxable interest and dividend income is posted from Schedule B to Form 1040, and is taxed as ordinary income. The income is added to your W-2 earnings and other income sources, and the total is used to calculate your total taxable income.
2. Understanding realized and recognized gains
If you sold any investments during the year, you’ll have a gain or loss on the sale. The institution handling the sale will issue a 1099-B Form, which lists the security that was sold, the date and cost of the purchase, and the sales proceeds you received from the sale. 1099-B also reports if the institution withheld any taxes on the sale on your behalf.
Investors need to know when they purchased each investment, which is referred to as cost basis. If you made multiple purchases over time, you’ll need the average cost basis for the investment.
Your investment firm should report cost basis on the 1099-B, but you should keep your own records of your investment purchases so that you don’t have to call the investment firm at tax time if any information is missing.
Many investors don’t understand the difference between realized and recognized gains, and the difference has an impact on the taxation of your investments.
Assume, for example, that Susie buys IBM common stock for $50 per share and sells it for $70. You need a buy and sell transaction to generate a realized gain, and Susie has a $20 realized gain per share.
A recognized gain, on the other hand, means a gain is a taxable event on your tax return, and not all realized gains are recognized gains.
Here’s an example of a realized gain that is not recognized: A house is an asset, just like stocks and bonds are assets, and selling a home generates a capital gain.
If you sell your primary residence and use the proceeds to buy a new home, a portion of your gain on the home sale may not be taxable. You may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of the gain if you file a joint return with your spouse.
If you sell stocks, bonds, mutual funds, or other assets during the year, check with a tax accountant to determine which gains must be recognized for tax purposes.
3. Working with short-term vs. long-term gains
A long-term gain is a sale of an investment that was owned for 12 months or more, and investments held less than a year generate short-term gains.
Matching gains with losses
The first step is to match long-term gains with long-term losses and to follow the same process for short-term gains and losses.
For example, if Susie has $40,000 in long-term gains and $15,000 long-term losses, she subtracts gains from losses to calculate a $25,000 net long-term capital gain. She also combines $10,000 in short-term gains with $5,000 in short-term losses to compute a $5,000 net short-term capital gain.
Computing your tax liability
Your net long-term and short-term capital gains are taxed at different rates.
Net short-term capital gains are subject to taxation as ordinary income, just like interest and dividend income. The capital gains are added to interest and dividend income, W-2 earnings and other income sources, and the tax rate is determined by your total income.
Your net long-term capital gains are taxed at a lower rate than the ordinary income tax rate. The tax rate on most net capital gains is no higher than 15% for most taxpayers, so you can benefit by holding investments longer and selling them as long-term gains.
The tax calculations for capital gains are complicated, even if you use tax software to prepare your return. Consider asking a tax preparer to review this section of your tax return so that the calculations are accurate.
4. Calculating the cost basis for a business sale
Cost basis refers to an owner’s total investment in a business venture, and most business owners post cost basis transactions incorrectly. When the owner sells the business, he or she cannot calculate the gain on the sale accurately, because the cost basis is incorrect.
The cost basis formula
Cost Basis is based on this formula:
Add your original capital contribution to the business plus any subsequent capital contributions.
Then subtract any capital withdrawals from your business. The result is the cost basis.
Capital is contributed to fund business operations, and owners may contribute cash or other assets, such as equipment. The owner may also contribute more capital as needed, perhaps to fund a business expansion.
Dividends vs. withdrawals
Dividends do not affect cost basis, but withdrawals change the cost basis calculation.
Dividends are a distribution of company earnings, and they are taxed as ordinary income to the owner. An owner can take out 100% of the annual earnings without changing the owner’s equity.
On the other hand, capital withdrawals refer to money taken out of the business that is more than the owner’s share of profits. If, for example, a sole proprietor’s business earned $50,000 and the owner took out $60,000, $10,000 is a capital withdrawal. Withdrawals reduce the owner’s basis in the business.
Finally, a company loan to an owner must be paid back before the sale is completed, so a loan would lower the dollar amount received on a business sale.
Cost basis is an important number because your capital gain on a business sale is calculated as sales proceeds less the cost basis. Work with an accountant to review changes in your costs basis balance each year.
The big impact on your taxes
If you own investments or a business, the tax liability on your income or capital gains can have a big impact on your total tax bill. To file an accurate tax return, use accounting software to prepare your return, and have a tax accountant review your transactions. Taking these steps can help you minimize the time you spend on your tax return.