10.1 Investment Taxation
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.
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:
Example: 4% muni yield for 37% bracket investor = 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:
The loss is fully deductible in the current year
The loss is disallowed and added to the cost basis of the new shares
Only 50% of the loss is deductible
The loss is deferred to the following tax year
A married couple filing jointly has $300,000 in wages and $50,000 in investment income. Their Net Investment Income Tax (NIIT) liability is:
$0 - They are below the threshold
$1,900 (3.8% × $50,000)
$3,800 (3.8% × $100,000)
$11,400 (3.8% × $300,000)
To receive qualified dividend treatment, an investor must hold the stock for at least:
30 days before the ex-dividend date
60 days during the 121-day period around the ex-dividend date
90 days before the record date
1 year before receiving the dividend
An investor in the 32% marginal tax bracket is considering a municipal bond yielding 4%. What is the tax-equivalent yield?
4.00%
5.26%
5.88%
6.25%
Sections you finish are checked off in the contents.