From Thomson-Reuters and the Pinnacle CPA Advisory Group —

If you invest in stocks, stock mutual funds, or stock ETFs, you’ve probably had a wild ride this year. You may have already realized some significant capital gains and some significant capital losses — especially if you’ve been buying the dips and then selling when prices rebound. You also may have significant unrealized capital gains and losses from positions that you still hold.

Of course, your 2022 tax situation is not final until year end. That’s when the results of all the trades made in taxable brokerage firm accounts will impact your 2022 tax situation. Positions that you still hold at year end won’t have any impact on this year’s tax situation.

Here’s what you need to know to avoid stock-market-related tax surprises for 2022.

If you have investments tax-favored retirement accounts

If you’ve had wild swings in the value of investments held in a tax-favored retirement account like a 401{k), traditional or Roth IRA, or self-employed retirement account such as a SEP account, those wild swings have no current tax impact. You almost certainly know that, but we want to cover the bases here.

It doesn’t matter if the wild swings are from executed trades made this year in your tax-favored retirement account or from fluctuations in the value of investments that you still hold in the account at year end. While the swings affect your account value, they have no tax impact until you start taking withdrawals. At that point, a higher account value will result in more taxes as you liquidate the account, and a lower account value will result in less taxes.

If you have a Roth IRA, qualified withdrawals taken after age 59½ will be federal-income-tax-free regardless of how much your account is worth.

Investments held in taxable brokerage firm accounts

From a tax perspective, your cumulative gains and losses from executed trades during the year are what matter. Unrealized gains and losses (paper losses) won’t affect your 2022 tax bill, although they can certainly affect your mental health. For the rest of this letter, we will focus on the tax impact of gains and losses from investments held in taxable brokerage firm accounts.

If You Have an Overall Loss for the Year. If your realized losses in taxable accounts for the year exceed your realized gains, you have a net capital loss for the year. Here’s the drill to determine the 2022 tax results:

  • Step 1: Divide your gains and losses into short-term gains and losses (from investments held for one year or less) and long-term gains and losses (from investments held for more than one year).
  • Step 2: If your short-term losses exceed the total of your short-term and long-term gains, you have a net short-term capital loss for the year.
  • Step 3: If your long-term losses exceed the total of your long-term and short-term gains, you have a net long-term capital loss for the year.
  • Step 4: Claim your allowable net capital loss deduction of up $3,000 (up to $1,500 if you use married filing separate status). First, deduct all or part of your net short-term capital loss from Step 2. If the full $3,000 ($1,500 if MFS) deduction is not used up, deduct all or part of your net-long capital loss from Step 3.
  • Step 5: Carry over any remaining net short-term or long-term capital loss after Step 4 to next year where it can be used to offset capital gains in 2023 and beyond.

If You Have an Overall Gain for the Year. If your gains in taxable accounts for the year exceed your losses, you have a net capital gain for the year. Good! Here’s the drill to determine the 2022 tax results:

  • Step 1: Divide your gains and losses into short-term gains and losses (from investments held for one year or less) and long­term gains and losses (from investments held for more than one year).
  • Step 2: If your short-term gains exceed the total of your short-term and long-term losses, you have a net short-term capital gain for the year.
  • Step 3: If your long-term gains exceed the total of your long-term and short-term losses, you have a net long-term capital gain for the year.

Note: You can potentially have both a net short-term capital gain and a net long-term loss capital gain.

Taxes on Net Short-term Capital Gains. A net short-term capital gain will be taxed at your regular federal income tax rate, which can be as high as 37%.

You may also owe the 3.8% net investment income tax (see below) and maybe state income tax too.

Taxes on Net Long-term Capital Gains. A net long-term capital gain (LTCG) will be taxed at the lower federal capital gain tax rates which can be 0%, 15%, or 20%. Most folks will pay 15%. High-income individuals will owe the maximum 20% rate on the lesser of:

(1) your net LTCG or (2) the excess of your taxable income, including any net LTCG, over the applicable threshold. For 2022, the thresholds are $517,200 for married joint filers, $459,750 for single filers, and $488,500 for heads of households.

You may also owe the 3.8% net investment income tax (see below) and maybe state income tax too.

Wash Sale Rule can eliminate tax losses

Regardless of whether you have an overall loss for the year or an overall gain, the Internal Revenue Code includes a trap for the unwary called the Wash Sale Rule. Under this rule, your tax loss from selling shares held in a taxable account is disallowed for federal income tax purposes if, within the 61-day period beginning 30 days before the date of the loss sale and ending 30 days after that date, you buy substantially identical securities.

The theory is that the loss sale and the offsetting purchase of substantially identical securities within the 61-day period amount to an economic “wash.” Therefore, you’re not entitled to any tax loss, and the tax savings that would ordinarily result from the loss are disallowed.

When you have a disallowed wash sale loss, the loss doesn’t just vaporize. Instead, the general rule is that the disallowed loss is added to the tax basis of the substantially identical securities that triggered the wash sale rule. When you eventually sell those substantially identical securities, the extra basis reduces your tax gain or increases your tax loss. In effect, the disallowed wash sale loss becomes a deferred loss that you can finally take into account when you sell the substantially identical securities.

Beware of the 3.8% Net Investment Income Tax (NIIT) if you have net capital gains

Individuals with net capital gains are potentially exposed to the 3.8% NIIT. The NIIT hits the lesser of your: (1) net investment income for the year which includes capital gains and dividends or (2) the amount by which your modified adjusted gross income for the year exceeds the applicable threshold. Find out if the NIIT applies to you. The thresholds are as follows:

  • $250,000 for married joint-filing couples
  • $200,000 if file as a single taxpayer or a head of household
  • $125,000 if you use married filing separate status

So, you could owe up to 40.8% to Uncle Sam on net short-term capital gains (37% + 3.8%). You could owe up to 23.8% (20% + 3.8%) on net long-term capital gains.

It’s a long time until year end

As stated earlier, your tax results for 2022 are up in the air until all the gains and losses from trades executed during the year are tallied up.

If you’ve got a net capital loss for the year so far, cheer up. Things could get better. If you’ve got a net capital gain for the year so far, don’t count your chickens. Things could get worse.

Contact KM&M CPAs

Contact the experts at Kleshinski, Morrison & Morris, CPAs if you need help with your capital gains/losses, or any other individual or business tax or accounting issue. Call us at 419-756-3211, send an email to kmm@kmmcpas.com, or simply fill out our contact form at this link.