Key Takeaways
- Long-term capital gains (assets held >1 year) are taxed at preferential rates of 0%, 15%, or 20%.
- Short-term capital gains are taxed as ordinary income at rates up to 37%.
- The Net Investment Income Tax (NIIT) adds 3.8% on investment income for high earners.
- Qualified dividends receive preferential long-term capital gains rates.
- Municipal bond interest is exempt from federal income tax.
- The wash sale rule disallows losses if substantially identical securities are repurchased within 30 days.
- Tax-loss harvesting allows investors to offset gains with realized losses.
- Cost basis methods (FIFO, specific identification, average cost) affect tax liability.
Investment Taxation
Understanding how investments are taxed is essential for making suitable recommendations and helping clients maximize after-tax returns.
Capital Gains Taxation
Capital gains occur when an asset is sold for more than its purchase price. The tax treatment depends on the holding period.
Holding Period Classifications
| Holding Period | Classification | Tax Treatment |
|---|---|---|
| 1 year or less | Short-term | Ordinary income rates (10%-37%) |
| More than 1 year | Long-term | Preferential rates (0%, 15%, 20%) |
2025 Long-Term Capital Gains Tax Brackets
| Filing Status | 0% Rate | 15% Rate | 20% Rate |
|---|---|---|---|
| Single | Up to $48,350 | $48,351 - $533,400 | Over $533,400 |
| Married Filing Jointly | Up to $96,700 | $96,701 - $600,050 | Over $600,050 |
| Head of Household | Up to $64,750 | $64,751 - $566,700 | Over $566,700 |
Net Investment Income Tax (NIIT)
High-income taxpayers may owe an additional 3.8% Net Investment Income Tax on the lesser of:
- Net investment income, OR
- Modified AGI exceeding threshold ($200,000 single, $250,000 married filing jointly)
Net investment income includes: Interest, dividends, capital gains, rental income, royalties, and passive business income.
Dividend Taxation
Qualified Dividends
Dividends that qualify for preferential tax treatment:
- From domestic corporations or qualified foreign corporations
- Must hold stock for 60+ days during the 121-day period around the ex-dividend date
- Taxed at long-term capital gains rates (0%, 15%, or 20%)
Non-Qualified (Ordinary) Dividends
Dividends taxed at ordinary income rates:
- REIT dividends
- Money market fund dividends
- Most foreign corporation dividends
- Dividends on shares held for less than 60 days
- Dividends paid on employer stock in ESOP
Tax-Advantaged Investments
| Investment | Federal Tax Treatment | State Tax Treatment |
|---|---|---|
| Municipal Bonds | Interest exempt | Exempt if in-state (often) |
| Treasury Securities | Interest taxable | Exempt from state/local |
| Municipal Bond Funds | Pro-rata exempt | Varies |
| Series I/EE Bonds | Tax-deferred; exempt for education | Exempt from state/local |
Municipal Bond Considerations
Tax-equivalent yield helps compare municipal to taxable bonds:
Tax-Equivalent Yield = Muni Yield ÷ (1 - Marginal Tax Rate)
Example: 4% muni yield for 37% bracket investor
= 4% ÷ (1 - 0.37) = 4% ÷ 0.63 = 6.35%
Tax-Loss Harvesting
Selling investments at a loss to offset taxable gains.
Offset Rules
| Gains/Losses | Offset Against |
|---|---|
| Short-term losses | First offset short-term gains, then long-term gains |
| Long-term losses | First offset long-term gains, then short-term gains |
| Net capital losses | Offset up to $3,000 ordinary income per year |
| Excess losses | Carry forward indefinitely |
The Wash Sale Rule
The wash sale rule disallows a loss if you buy "substantially identical" securities within:
- 30 days before the sale, OR
- 30 days after the sale
This creates a 61-day window (30 + 1 + 30) where repurchasing triggers the rule.
Key points:
- Applies across ALL accounts (taxable, IRA, spouse's accounts)
- Disallowed loss is added to the cost basis of the new shares
- Holding period of original shares transfers to new shares
- Cryptocurrencies are currently exempt from wash sale rules
"Substantially identical" includes:
- Same stock or security
- Options or contracts to acquire same stock
- Convertible securities in the same company
Cost Basis Methods
| Method | Description | Best For |
|---|---|---|
| FIFO (First In, First Out) | Oldest shares sold first | Default method |
| Specific Identification | Choose which shares to sell | Tax optimization |
| Average Cost | Average of all share costs | Mutual funds only |
| LIFO (Last In, First Out) | Newest shares sold first | Not common |
Tax Lot Selection Strategy
To minimize taxes: Sell shares with the highest cost basis first (maximize loss or minimize gain).
To maximize taxes (for lower income years): Sell shares with the lowest cost basis.
Exam Tip: Long-term = MORE than one year = LOWER tax rates. The wash sale rule creates a 61-day window (not 60). NIIT is 3.8% and applies to investment income over certain thresholds.
An investor sells stock at a loss on December 1 and purchases the same stock on December 15. Under the wash sale rule:
A married couple filing jointly has $300,000 in wages and $50,000 in investment income. Their Net Investment Income Tax (NIIT) liability is:
To receive qualified dividend treatment, an investor must hold the stock for at least:
An investor in the 32% marginal tax bracket is considering a municipal bond yielding 4%. What is the tax-equivalent yield?
10.2 Estate Planning Basics
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