The biggest story on Wall Street this week hasn’t been the challenging employment numbers or disappointing corporate earnings. Rather it has been the frenzy around GameStop and the group of investors taking on institutional hedge funds. It is a wild ride that everyone seems to be watching, and it is looking like it might not end quickly – or painlessly.
But there is someone else watching this fight between David and Goliath: the Internal Revenue Service. Trading creates taxable transactions. If investors are not careful, they may be triggering significant tax implications for themselves.
“Investors should consider the tax impact of their trades because all profits made from trading stocks are taxable. Oftentimes investors think they are entitled to the full amount of profits, especially new traders,” says Colin Horsford, CPA and Managing Partner of Horsford Accounting & Advisory in New York City.
While potential tax ramifications might not change investors’ behavior, being aware of the consequences can help them prepare for when the tax bill comes due.
Short Term Gain versus Long Term Gain
Timing matters when it comes to investments and tax. Gains that are generated on investments held longer than a year and a day are considered long term capital gains. These gains are taxed at preferential rates ranging from 0%, 15% or 20% depending on the investors tax bracket. The Net Investment Income Tax of 3.8% might apply for single taxpayers with adjusted gross incomes above $200,000 and married taxpayers who make more than $250,000.
But a gain on investment that is sold in less than a year is considered a short-term gain. These gains are subject to tax rates that are not preferential and the tax bite can be quite painful.
“Short term gains are taxed at ordinary income tax rates. For top bracket taxpayers, it is approximately 37% as opposed to being 23.8%,” explains Randy Abeles, CPA and Member of the AICPA’s Personal Financial Specialist Committee. “That is a big difference of 14 percentage points.”
While not all investors are subject to the top tax bracket, paying ordinary income tax rates on their gains can still hurt the bottom line.
“The majority of the investors profiting off GameStop will most likely fall into the short-term capital gains territory since they are buying and selling within short periods. Those investors will have to report their capital gains on their 2021 tax return and pay taxes on it,” says Horsford.
This isn’t to say all investors in the GameStop frenzy will pay large tax bills. There is a chance for those investors who have income below certain thresholds to be subject to little tax.
But Abeles points out this will likely be a small group. “Typically when you are trading and doing short sales you have more income because you have more income to risk. If your income rates are lower, you might not pay any tax. Assuming it is a single person who only made a few thousand dollars, they aren’t going to be paying any tax.”
But short selling can lead to murkier tax situations. When short selling, it is important to note that the investor does not own the underlying shares when they begin the transaction. Rather, shares are borrowed, and the investor purchases them when they are paying back the borrowed shares. The timing of this can create numerous tax issues.
“It is possible to have a short sale open for greater than one year but have the capital gains taxed as short-term since the shares weren’t truly owned by the investor but for a short period at the end of the transaction,” explains Horsford. “There are many other complex tax reporting rules that may apply depending on the short-sale transaction so investors should work with an experienced CPA or tax preparer to make sure it is reported correctly.”
Further, there is no way around not reporting these gains correctly.
“The investor’s brokerage firm will report all gains to the IRS and will in turn send them a Form 1099 outlining the total gains to be reported on Form 1040. Failure to report capital gains accurately to the IRS can lead to penalties and fines,” says Horsford.
A Year To Plan For The Pain
It is important for investors to factor taxes into their planning. Current GameStop investors, given that the transactions are happening at the beginning of the year, must be aware that the pain from taxes might not be felt for over a year, when they file their 2020 returns in April 2021.
“It is always a good idea for investors to sock away a portion of all trading profits for tax purposes, so they aren’t surprised by a large tax bill come tax time,” advises Horsford.
But in the meantime, many are simply enjoying the ride of watching their investments.
This is an article feature that originally written by Megan Forman and appeared in Forbes Magazine.
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