Even though the market flat-lined in 2005, you still may have a capital gains tax bill on your return this April. Gotta love that. No growth -- just taxes. Yippee. So if you sold a stock or got a dividend distribution, expect to owe tax. Remember, Uncle Sam always gets a cut. And while you probably just want to close the book on your once-darling stock that's now worthless, you may be able to declare a loss on that holding and offset all the other taxes you're going to owe. So let's tackle these seemingly unfair issues and hopefully save you some money in the process.
A Capital RefresherIf you sell a security for more than you paid, you'll owe capital gains tax on the difference. To calculate that difference, be sure to include your commission fees. Any commissions paid to purchase the shares is added to your basis, or purchase price. So if you bought $100 worth of stock and paid a $5 commission to get those shares, your basis is $105. Let's say you sold those shares for $125, 13 months later. If you paid another $5 to make the trade, your proceeds are $120. That makes your total gain -- or profit from the transaction -- $15 ($120 - $105). This transaction should be reported on Schedule D -- Capital Gains and Losses and you'll owe capital gains tax on the profit. The rate you owe will depend on how long you held the shares. If you held the shares for more than a year before you sold them, you'll qualify for the long-term capital gains rate, which is 15% (5% if your ordinary income tax bracket is 15% or lower). That's the rate you'll use for the long-term sale of stocks, mutual funds, or even ETFs.
Short-term capital gains are generated from assets held less than a year. Those gains are taxed at your ordinary income tax rate. So if you're in the 35% tax bracket and made $100 on a stock you held for four months, expect to owe $35 in capital gains tax. The low long-term rates are expected to expire in 2008, reminds Fred Stein, a tax analyst with RIA, a Thomson business and provider of tax information and software to tax professionals. And while many folks in Congress are pushing for these rates to be permanent, keep that date in mind for planning purposes. Remember, you can apply your capital losses against your capital gains and thereby wipe out that tax bill. In addition, you can declare another $3,000 in losses (or $1,500 if you are married filing separately) on your tax return. So let's say you have $15,000 in losses but only $10,000 in gains. You can offset that gain with $10,000 in losses. Of the $5,000 remaining losses, you can claim another $3,000 this year. The remaining $2,000 loss must be carried forward to next year. And you can carry forward those losses until they're used up.
Qualified Quirky Dividend RuleDividends are always a nice perk from your stock or mutual fund holdings. And many of us opt to have those dividend distributions reinvested back into the asset. But remember, just because you don't get to play with that money, you still owe tax on that distribution. And if the fund or the stock is in the toilet, that tax bill just adds insult to injury. To make matters worse, the dividend tax rules are a bit hairy. Prior to the 2003 Jobs and Growth Tax Reconciliation Act, dividends were taxed at your ordinary income rate, which could be as high as 35%.
Congress changed that with the 2003 tax act. Now the rate is 15% (5% for taxpayers in the lowest two tax brackets) on "qualified dividends" only. For your dividends to be "qualified," you must have held the security that issued the dividend for more than 60 days before or after the ex-dividend date (the date you need to be a shareholder to qualify for the actual distribution). As an example, let's say you bought shares of a stock the day before its ex-div date. You'll need to hold those shares for at least 61 days to take advantage of the 15% rate on your distribution. The reason: No one wants you to flip the stock just to get the dividend. And that includes your mutual fund manager. You both have to meet the rules. Not only do you need to hold the fund shares for the requisite 61 days, but the actual shares have to be held in your fund for either 60 days before or after the security's ex-div date. So if your manager isn't paying attention, you'll get burned with a big tax bill. Your Form 1099 should tell you whether your dividends passed the test. But do your own homework. The brokerage houses made mistakes reporting this stuff in the past, so be skeptical. And again, this 15% qualified dividend rate is also scheduled to expire in 2008, reminds Stein.
Is All This Really Worthless?If big names like Gateway ( GTW) General Motors ( GM) and Ford ( F) could fall 56%, 48% and 44%, respectively, in 2005, it's no surprise that other less-established companies just closed up shop and became worthless securities. But is your stock really worthless? The IRS' definition of a worthless security is so vague that you better be able to back your rationale. The mere declaration of bankruptcy doesn't mean a thing, Stein says. Companies (and individuals) go in and out of bankruptcy all the time.
You need solid facts, so expect to do some serious research. Don't rely on the company to get in touch with you and declare its stock worthless -- it's got bigger problems than keeping its shareholders happy. So what makes a stock worthless? Here are a few possibilities:
The liabilities of the company way exceed its assets and there's no way they're going to get paid off, meaning the company will most likely never make money again. The company is insolvent because everything was sold or the owners took off to Tahiti with it all. The liquidating value of the stock is zilch, and will continue to be in the foreseeable future. If you truly think your stock is worthless, then go ahead and write off that loss. But know this: You can only record that loss in the year the stock went belly-up, says Stein. So if the stock was considered worthless in 2004, don't think you can claim it on your 2005 return. You'll have to go back and amend your 2004 return to get that benefit. If your stock was officially considered toilet paper in 2005, report it on Schedule D as though you sold it for $0 on Dec. 31. Just write "worthless" in the section that asks for the sale date and selling price. Be sure to check out IRS' Publication 550 -- Investment Income and Expenses for more grist on worthless securities and all your other capital gain issues. That should take care of most capital gains concerns for investors. Next, we'll tackle more esoteric trader topics. So stay tuned.