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Avoid taxes on stock gains
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October 8, 1999: 6:23 a.m. ET
Online trades can lead to large burden if you're not careful
By Staff Writer Nicole Jacoby
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NEW YORK (CNNfn) - Maybe you were a little eager when you opened your first online trading account.
As markets soared and sank, you bought and sold shares as fast as your 28.8 Internet connection would allow. Luckily, your picks paid off, with double-digit gains dominating your portfolio.
But before you kick back, put your hands behind your head and rest your feet on your desk with a satisfied smirk, consider this: those profits might be seriously undercut by hefty taxes come next April.
Stocks that are held for less than 12 months are subject to the same taxes as your ordinary income. Depending on your tax bracket, you could be paying as much as 39.6 percent in taxes on those stock gains.
Conversely, shares that are held for more than 12 months -- deemed long-term investments by the Internal Revenue Service -- are taxed at a maximum of 20 percent.
But before you panic and swear off short-term trading forever, you might want to take a closer look at your overall investment strategy.
"Economics should always be paramount over tax considerations," said Robert Mason, a Phoenix-based certified financial planner. "Don't let the tax tail wag the investment dog."
Making the call
Whether short-term trades are worth it depend greatly on how much money you are making.
If you are in a high tax bracket -- 31 percent, 36 percent or 39.6 percent, for instance - holding your shares beyond the one-year mark can greatly reduce your tax liability. But if you are in a lower tax bracket to begin with, the difference in taxes between short and long-term investments will be less noticeable.
More importantly, if the returns on your investment are significant, perhaps above 20 percent, the taxes on that gain may be a small price to pay.
Under no circumstances should you hold on to a stock simply to avoid short-term taxes. If you believe the stock's value is about to plummet or you have a more lucrative alternative investment in mind, you should sell.
"Lower taxes are great, but if its going to cost you money, it's not worth it," said David Mellem, an enrolled agent and research manager for the National Association of Tax Practitioners. "If a stock hits your sell range after 3 months, do you really want to risk 9 more months of fluctuation to get a lower tax rate?"
Some investors make the mistake of focusing so closely on taxes that they give up formidable investment returns. A better strategy is to put aside the amount of cash you're likely to need to make up for capital gains, so you're not scraping together the funds come April 15.
"If you are making a lot of money from short-term trading, taxes are just the price you pay for being successful," said Mason.
(To calculate whether it's worth your while to hold your shares for 12 months, click here.)
Counteracting gains
Short of a miracle, there's not much you can do to roll back the profits -- and the subsequent tax consequences -- of winning stocks you've already cashed in.
"Once you've done the sale, the only way to fix that is with a time machine," said Mellem. "But you can take steps to minimize the (tax) impact."
Simple strategies include donating more to charity to increase write-offs or making a few early real estate tax payments.
"What you normally pay in January and February, you can pay in December instead," recommends Mellem.
But the best way to offset capital gains is to declare capital losses. Up to $3,000 in net capital loss -- $1,500 for those married and filing separately -- can be claimed on your return each year, and net losses that exceed that figure can be carried forward into future years.
(Click here to find out which stocks you should sell to help reduce your taxes.)
Capital losses are not limited to stocks, though those might be the easiest to unload. Real estate and other property investments, along with stamp and coin collections, can be written off as well.
There is one caveat to selling losing stock. If you repurchase the losing stock within 30 days, it no longer qualifies as a loss on your tax return. This is known as the "wash sale rule" and it can have significant tax consequences.
For instance, you buy 50 shares of a stock valued at $10 apiece. Months later, an earnings warning is issued and you sell your stock at $8 a share, a loss of $100. A few weeks later, a restructuring is announced and you buy back 50 shares at $12 apiece.
The wash sale rule forbids you from taking the original loss on your tax return, so your basis or your investment in the stock has jumped to $700 -- the $600 spent on the most recent purchase and the $100 loss.
Whenever possible, you should avoid repurchasing stock within 30 days. But if a buyback seems too good an investment to pass up, be sure to keep track of your purchases and sales.
"It's really important to keep good records," said Mason. "A lot of people don't realize they have a gain problem until the end of the year."
The importance of record-keeping
Clear and accurate records can be a big help when tax time arrives. Although your brokerage will send you Form 1099, listing all stock sales made over the past year, that statement does not include purchases.
The investor is personally responsible for recording the dates and dollar amounts of all stocks purchases made. Without this information, it may be nearly impossible to determine your basis and holding period of individual shares.
If you cannot prove what you paid for a share, Uncle Sam will use the figure zero or a "reasonable" estimate, which may be lower than what you actually paid. A reasonable estimate may be the median of the high and low price of the stock in the applicable year.
Because the IRS will usually go with a lower basis than you paid for the stock, your gains will appear bigger, making you liable for higher taxes.
Records also become important when a company splits its shares or spins off a unit, significantly changing the value of the stock.
"You're going to need all that information to determine cost to calculate your gain or loss at a later date," said Mellem. IRS Publication 550 has more information about reporting investment income and expenses, including capital gains. 
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