Your stocks are a capital asset, along with just about everything else you own. If you sell your stock for a profit, the Internal Revenue Service wants its cut in the form of a capital gains tax. Unlike most of your other personal property, if you sell your stock for a loss, you can use that loss to offset your capital gains or reduce your other taxable income.
Stock You Buy
Buying stock does not create a taxable event. As far as the IRS is concerned, you could have spent your money on a new boat, used that money to take a vacation or put it under your mattress. You don't report your stock purchase to the IRS, and you don't pay income taxes on your purchase transaction, but you still need to keep documentation of the transaction to help determine the cost basis of your stock for when you decide to sell sometime in the future.
If a company earns a profit, its board of directors might choose to pay a portion of those profits to the stockholders in the form of a dividend. The company should provide you with a Form 1099-DIV detailing the amount of dividends it paid you. You must report all stock dividends you receive when you file your federal income tax return, regardless of the amount and regardless of whether you received a Form 1099-DIV. Ordinary dividends are taxed as ordinary income.
Stocks You Own
While you have to pay taxes on any dividends you receive, you don't pay taxes on stock you own, regardless of how long you own it. You can buy stock at $2 per share and hold it for 50 years or more. The stock might appreciate to $200 per share or more, and you would still not owe any income taxes on it. You are not taxed on your stock until you sell it.
Stock You Sell
When you sell your stock, you create a taxable event. If you sell your stock for more than you paid for it, you have a taxable capital gain. If you owned your stock for more than one year, the IRS considers the gain to be long term, and the gain is taxed at the more favorable long-term capital gains tax rate. If you owned your stock for one year or less, the IRS considers the gain to be short term, and the gain is taxed at your ordinary income tax rate. If you sell your stock for less than you paid for it, you can use that loss to reduce your taxable income.
Don't make the mistake of reporting the total amount of your stock sale as a capital gain. You are only liable for taxes on the difference between what you paid for the stock and what you sold it for. You can add the cost of buying your stock, such as commissions and brokerage fees, to the purchase price of your stock to determine your cost basis, and you can subtract those same expenses from the sale price to determine your final sale price.
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.