Investors buy stocks in hopes of making money from capital gains, dividend payments or both. The tax treatment of capital gains is different than for ordinary income like interest and your salary. You have no taxes to pay when you buy stock, but you might have to pay income taxes on capital gains when you sell the shares.
When you buy stock, you acquire what the Internal Revenue Service calls a capital asset. The price of the shares may go up or down after you purchase them. Eventually, you’ll probably sell the shares. If their sale price is more than you originally paid, you have a capital gain. If the share price falls, you’ll end up with a capital loss when you sell. Capital gains are taxable income. Losses can be written off when you file your tax return.
Cost basis, or tax basis, is the total investment you make when you buy stock. Cost basis is equal to the price of the shares plus any added expenses like broker’s commissions. For instance, if you buy 50 shares of a company’s stock for $25 per share, that’s $1,250. If you pay your broker $50, the cost basis is $1,300. When you sell the stock, subtract the cost basis from the net proceeds to figure your capital gain. Net proceeds mean the sale price minus any expenses for selling the shares. If the net proceeds are more than the cost basis, you have a capital gain.
A capital gain is long-term if you own the shares for more than a year before selling them. The maximum tax rate on long-term gains is 15 percent. If you keep the stock for one year or less, it’s a short-term gain, and you pay taxes at ordinary tax rates. Capital losses are also either long- or short-term. This matters because long-term losses have to be used to offset long-term gains on your tax return, and short-term losses used to offset short-term losses. Any losses remaining can be used to offset gains of the other type. If there are still any leftover losses, they can be used to offset other income.
Dividends on stocks are not capital gains. A dividend is a distribution of some of the profits a company earns to its shareholders. Dividends on stocks are normally ordinary income and taxed accordingly. This includes dividends received through a dividend reinvestment plan that are used to buy more of the company’s stock. AS far as the IRS is concerned, reinvested dividends are still ordinary income, and you pay taxes in the year you get the dividend. Always add the amount of reinvested dividends to your cost basis. Otherwise, you won’t subtract enough from your net proceeds when you sell the stock, and you’ll end up paying too much tax on capital gains.
Based in Atlanta, Georgia, W D Adkins has been writing professionally since 2008. He writes about business, personal finance and careers. Adkins holds master's degrees in history and sociology from Georgia State University. He became a member of the Society of Professional Journalists in 2009.