Tax Consequences of Purchasing Stock Below Fair Market Value

Identifying undervalued stocks can be a great investment strategy.

Identifying undervalued stocks can be a great investment strategy.

Stock market gains are subject to federal capital gains tax. Therefore, purchasing stocks well under fair market value can result in a substantial profit, which can lead to a hefty tax bill. The ultimate tax liability, however, depends on how long you hold the stocks as well the gains or losses in the rest of your portfolio. Understanding the intricacies will help you manage your tax bill.

Realized vs. Paper Profit

When you buy an asset and its profit climbs above your purchase price, while you are still holding it, you are said to have a paper profit. The gain is referred to as such because it only exists "on paper" and has not yet been realized as a true profit. Hence, such gains are also called unrealized profits. When you sell the asset for a price that exceeds your purchase price, after deducting the applicable fees and commissions, you are said to have a real or realized profit. The Internal Revenue Service only taxes realized profits and is not concerned at all with paper profits.

Short-Term Capital Gains

Once you obtain a net realized profit from a stock sale, the IRS calculates the amount of time between your sale and purchase. If less than a year has passed, the profit is classified as a short-term capital gain. Such gains are added to your ordinary income and taxed at the tax rate you qualify for after all deductions and provisions in the tax law. For 2013 ordinary income tax rates were between 10 percent and 39.6 percent. If your taxable ordinary income is particularly high during a given year, it might make sense to wait until the following year to sell your winning stocks.

Long-Term Capital Gains

If exactly a year or more has passed between your purchase and sale of a stock, the gain is considered a long-term capital gain. Such profits are taxed anywhere from zero to 20 percent for most taxpayers. The higher your ordinary income, the higher the long-term capital gains tax you must pay. If your ordinary income is sufficiently low and you fulfill other requirements, your long-term capital gains may be fully exempt from taxation. The same rule applies not only to stocks but also many other capital assets, such as bonds and precious metals, including gold and silver.

Investor's Dillemma

When you buy an undervalued stock, the stock may appreciate slowly over time, make a few big leaps or fail to appreciate at all and further decline. If the gains are slow and steady, it might make sense to wait a year and sell the stock only when the resulting gains will qualify as long term. If the stock makes a few big leaps, however, you will likely face a dilemma. Especially if the stock has a history of both up- and downswings, the next wave of price drops may erase a substantial portion of the gains. The right strategy depends on the context.

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