When you trade stocks, three things can happen. You can make a profit, you can take a loss, or you can break even. If you make a profit, the Internal Revenue Service wants its cut in the form of capital-gains taxes. How much tax you have to pay on your gains depends on how long you've held your stocks, and whether the IRS considers you to be an investor or a trader.
Investor vs Trader
A trader is someone who is in the business of buying and selling securities for his own account. You are probably not a trader, at least as far as the IRS is concerned. Even if you trade stocks on a regular basis, say several times a week, you are still probably an investor. Traders seek to profit from short-term swings in the market without regard for dividends or capital appreciation. They must be actively, regularly and continuously involved with trading, and their activity must be substantial. Traders trade in order to produce income as a means of their livelihood. They are taxed at the same rate, but they get to write off more expenses.
Whether you are a trader or an investor, you still have to pay capital-gains taxes on your profits from trading. Simply put, the amount of your capital gain is the difference between what you paid for your stock, plus commissions, and what you sold your stock for, minus commissions. If you held the stock for one year or less, your profit is taxed at your ordinary income tax rate as a short-term capital gain. If you held the stock for more than one year, your profit is taxed at the more advantageous long-term-capital-gains rate.
If you have traded stocks for any length of time, you've probably had some losses as well as gains. While nobody likes losses, you can at least use them to offset some of your gains and reduce your tax bill. If your trading losses exceed your gains you can even write off up to $3,000 of your non-investment income, such as your W-2 wages.
Net Capital Gains
Figure your net capital gains by completing Form 1041, Schedule D of IRS Form 1040. Once you've offset your trading by your losses, if you have a profit, it is considered a net capital gain. The net capital gains tax rate is set by Congress and fluctuates from time to time. For the 2012 tax year, the maximum net capital-gains tax rate is 15 percent, in most cases, but there are some exceptions. For example, the maximum net capital gains tax rate on Section 1202-qualified small-business stock is 28 percent.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.