When you invest in the stock market, the Internal Revenue Service is not interested in your profits or losses until you cash in the stocks. Before then, you could see the value of your stocks skyrocket and your portfolio value quadruple overnight, but the IRS would not care. Similarly, if your portfolio value hits rock bottom, you cannot claim a loss on your taxes unless you sell those stocks.
Long-Term vs. Short Term Gains
When you sell a stock for a profit, the way those profits are taxed depends on how long you have held the stock before selling it. If you have held it for at least one year, the IRS will consider it a long-term, or capital, gain. If you held it for less than a year, it is classified as a short-term gain.
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The difference is significant, because the IRS imposes a higher tax rate on short-term gains than it does on capital gains. As of 2010, the maximum tax rate for capital gains is 15 percent. If you fall into a lower tax bracket, your capital gains tax rate may even be 0 percent. With short-term gains, your gain is counted as ordinary income, so whatever tax bracket you fall into, that is the tax rate applied to your gain. As of 2010, the highest tax bracket for ordinary income is 35 percent.
If you suffer a loss on your investments, you can use those losses to offset your capital gains for the year. For example, if you lose $3,000 on a stock sale but have $4,000 in capital gains, you only have to pay taxes on $1,000 of those gains. Better yet, if your losses exceed your gains, you can claim a loss of up to $3,000 per year and carry forward any excess to offset capital gains in future years.
However, you must be careful about wash sales, or buying back a stock around the time you sold it to claim a loss. The IRS considers a wash sale buying shares within 30 days, before or after you sell the stock, to claim a loss. These losses are disallowed.
To report your gains or losses, you must file the IRS's Schedule D and use Form 1040 to file your income tax return. On Schedule D, you will have to detail the stocks you sold, how long you held them and your profits or losses. The taxable amount will be transferred to the income section of Form 1040. If you have a net loss, you don't have to itemize your tax deductions to claim the loss.