Ordinary Income vs Capital Gains

In January next year some people may get stunned when they receive the tax report for their investment account which has exposure to the mortgage industry: portfolio shows a loss but tax must still be paid for realized interest income.The reason for that is because IRS treats incomes differently.

The Internal Revenue Code classifies income into three kinds: Earned Income,Passive Income,and Portfolio Income of which profit from stock investing or trading belongs to Portfolio Income.

Portfolio Income is divided into Investment Income and Capital Gain or commonly called ordinary income and capital gain.To keep it as concise as IRS’definitions,the term “investment income” will be used in this article instead of “ordinary income”.

Investment income includes dividends from stocks and interest from bonds.Expenses such as interest paid on loan used to buy and hold the stocks and bonds can be deductible up to the total investment income in that year.For example,an account is charged a total of $800 in loan interest and produces an investment income of $1,000 then the maximum deduction is $800 for that year,the net investment income to file is $200.

In 2003 tax law revisions allow the cap rule of 15% for cash dividends from common and preferred stocks that are held for more than 60 days of 120 days window with ex-date (say,ex-date is 03/31,then minimum holding time is 03/01 through 04/30).That is a maximum of $15 per $100 dividends.These tax revisions create a huge loophole for many hedge funds such as the Blackstone Group scandal this year.The revisions are not applicable to interest from bonds,REITs,bond mutual funds,stocks that are lent to short sellers.

On the form 1040 Tax Return total dividends are reported on line 9a,the 2003-revision-qualified dividends will be entered on line 9b (“qualified dividends”).

Capital gain is gain realized from selling stocks (or any assets).Capital loss can be deductible up to the capital gain plus $3,000 maximum cap.The excess of loss cap will be carried over to the next year.For example,an account has a capital gain of $6,000 and capital loss:$10,000.How much can be deductible ? How much can be carried over to next year? The account net loss is 10,000 – 6,000 = 4,000.The amount of loss can be carried over to next year is 4,000-3,000=1,000.

Tax law divides capital gain into long term (asset held over 12 months) and short term (assets held up to 12 months).Short term capital gains will be taxed at tax bracket up to 35%.Long term capital gains will be taxed at maximum 15%.Loss can be used to deduct against both long and short term gains.For example an account gets a short term loss of $3,000, a short term gain from other trades of $1,000,a long term gain of $5,000, a long term loss of $1,000;then,the total loss is $4,000, this amount can be used to deduct against the total gains of $6,000 so the net $2,000 gain will be counted as long term gain.This tax strategy is so called “short term loss,long term gain” and widely used by investors.It is rather spending money to hedge a winning position than booking a short term gain. Day or short term traders lose this advantage.

A few more things should be noticed:

Investment income can not be offset by capital loss that is the reason a portfolio experiences a loss but an investor still has to pay tax for realized gain.

Dividends are counted on the date they pay (ex-date).Stock dividends are not counted as investment income but used to adjust to cost basis per share.Acquired stocks and their sales are counted on the trade dates,not the settlement dates.Commissions are added to purchases and subtracted from sales.For example,a person buy 100 sh of ABC stock at $60/share plus $40 of commission,the cost basis per share is (60×100+40)/100=$60.40/share,then the company pays 20% dividends now the cost basis is 60.40/1.20=$50.33/share.

Wash sale: IRS considers a sale is a wash sale if an equivalent position is established 30 days before or after that sale;for example a person sells 100 shares of ABC stock on 12/18 if he buys the same position in 30 days either before or after 12/18,the trade is still considered a wash sale and it may result in an audit and penalty.

These are just some basic rules that regulate the investing in stocks.One of most considerable rule is the large different tax rates applied to long term and short term gains;it is not overstated to say that the portfolio performance heavily depends on the skill of tax management;high tax bracket individuals are encouraged to consider the tax efficiency above portfolio performance in selecting a mutual fund.