This is a guest contribution by Ratio CPA for SureDividend
When we talk about stock investment, everything is based on understanding how taxes work. Since you are reading this blog, you must be interested in this topic, but you will need more than basic knowledge to gain its full benefits.
Once you accept this, you have to devote time to understanding taxes. Then it will be easier to have peace of mind knowing you are finally earning money even when you are asleep. Sound tempting? Of course – every intelligent decision does.
In this blog, you will find professional advice from Certified Public Accountants who are pros at leading their clients through the world of taxes. Pro tips from a CPA will help you learn which securities you can use to gain more than just an introductory lesson in Economics 101.
So, let’s get started – pencils up!
We’ll start with demystifying the more common terms you’ve heard about taxes and stock investments.
In this article
What is a Tax on Active and Passive Income?
Active income refers to ordinary rates and social security. The tax on active income is usually imposed at federal and state levels. This form of tax applies to every employed citizen in the USA.
Active income makes up 88% of the entire tax fund of the USA. So even if you are not directly going to the bank to pay your taxes, as an employed person, you divide your earnings 50 – 50 with the business owner, who is obliged to pay taxes to the USA from part of your salary.
This is called an ‘active’ tax model because tax rates on active income are permanently fixed and set mainly by the government, so there is no direct personal gain from it.
Passive income is generally defined as income earned without an active effort on the part of the individual receiving the income. Unlike active income, passive income doesn’t include social security taxes. Plus, passive income is taxed at a lower rate. That is why it is called passive.
Renting is the type of investing that is an attractive option compared to other types that offer less security, stability, and return on your money. Investment properties allow for the generation of passive, recurring net income and potential profits from property value appreciation.
If you have real estate, on the other hand, you have 1031 exchanges, which can be used to buy more 1031 exchanges, or you can invest in qualified opportunities. A 1031 exchange is a tax-deferred exchange of property used for investment purposes. This means you can sell one piece of investment property and use the proceeds to purchase another without paying any capital gains tax on the sale.
To take advantage of a 1031 exchange, the old and the new properties must be held for investment purposes and be “like-kind” properties.
Tax on passive income is a term used to describe the taxation of earnings from investments, real estate, and other activities that produce passive income.
There are a few different ways to get passive income:
- Investment income: Interest, dividends, and capital gains from investments are all considered passive income.
- Rental property: Income from renting out property is considered passive income.
- Royalties: Royalties from books, songs, or patents are considered passive income.
To get the most benefit from taxes on passive income, it’s crucial to understand how each type of passive income is taxed.
What Are the Short and Long-Term Capital Gains?
When investing, there are two paths – short and long-term gain. You get a short-term gain when you hold your stocks in your possession for one year or less, and long-term gain stands for stocks that you hold for more than one year.
Short-term capital gains are generally considered a form of active income, while long-term capital gains are a form of passive income. This is because the short-term typically requires more effort (and therefore risk) on the part of the investor, while the long-term typically involves less work on the part of the investor.
What is Capital Gains Tax?
A capital gains tax is the tax on profits realized on the sale of a non-inventory asset. The most common capital gains are from selling stocks, bonds, precious metals, real estate, and property. For example, if you purchase stock for $1,000 and sell it for $2,000, you’d have realized a $1,000 capital gain.
Capital gains are generally taxed lower than ordinary income, such as wages or interest. This is because capital gains are considered to be a long-term investment.
How to Eliminate Capital Gains
One of the first ways to eliminate capital gains is by generating other capital losses. Let that sink in. This sentence will have a meaning in a minute.
When it comes to taxes, there are different rules for different types of income. For example, capital gains from the sale of investments are taxed at a lower rate than ordinary income from wages or salaries. However, if those capital gains are classified as “short-term,” they will be taxed at the higher ordinary income tax rate. The same is true for other types of passive income, such as royalties and interest payments.
So, if capital gains are short-term, all passive income, like royalty and interests, is counted as ordinary tax. As a result, they all add up in your ordinary bracket.
This is why it’s essential to understand the tax implications of different types of income. Otherwise, you could end up paying more taxes than you should.
Capital gains are offset only by capital losses. Or better, capital losses offset capital gains. So you can’t lose your money if you keep investing and stop selling. And that is Economics 101 – you have to keep the circle of money alive if you want to stay in that circle.
And before you exit, because this sounds like you need a lot of money, you must know that to avoid capital gains tax, you must have stocks in your possession because that will provide you with options. For example, you can trade stocks or get a loan based on how much money you have in stocks.
So it is all about holding. But how is this profitable to the companies selling their stocks and the government? What do they gain from having holders of their stocks? To understand this, we must fast forward to another term.
What are Dividends?
This common term among economics students strikes right to the heart of this subject. Dividends are the reason why wealthy people stay wealthy. Take Elon Musk, for example. All you hear is Elon Musk is buying this or that; you rarely hear about what he’s sold. And that is what intelligent people do; they hold their wealth for ages and only focus on increasing it. And how do they do that?
First, they have a team of CPA experts by their side, who have one and one job only to track every possible tax regulation, law news, trend, new deduction, and opportunity that can be an open window for gaining money on existing investments. And second, they buy dividends. Dividends are long-term capital gains that are special from all the other assets.
They are different from other stocks because they have an impact only on a long-term basis. For example, suppose you possess stocks from Coca-Cola, McDonalds, or some local company like LOW with a good dividend payment ratio. All those companies pay dividends to their shareholders. They are sharing a profit with you. So, dividends are the payments you receive as a shareholder just for holding that stock. And that could be taxed at zero. Most of those payments come quarterly, meaning you receive four per year, but sometimes it changes monthly or annually.
Dividends are a type of investment income paid out by a company to shareholders regularly. Unlike other types of income, dividends are not earned through diligent active work but are generated passively by owning shares in a company.
While dividends can provide a helpful income stream, they are also subject to market fluctuations and can go up or down over time. For this reason, it is important to diversify one’s portfolio and not rely too heavily on dividends as a source of income. Although they can be a valuable part of an investment strategy, dividends should not be investors’ only source of income.
How to Use Dividends in Your Favor
Most of the money that comes from dividends is from the company’s profit. So they choose whether to reinvest or sell stocks as dividends. This split of profit is known as the payout ratio. So, for example, if some particular company shares their profit 50-50 on reinvestment and dividends, their payout ratio is 50%.
The amount of your dividend payments depends on the number of shares you own. For example, you have five shares at $20 each. The company decides to pay a 0.25 cent per quarter dividend, which means you will have 1$ for each share you own in the form of a dividend by the end of the year. Divining those numbers ($1/$20 = 5%) will give you the dividend yield.
And that percentage is essential when it comes to choosing which company to buy stocks from.
You can see how much specific companies have increased their dividend yield over the years. And always track how many years in a row they raise their dividend payouts.
Some companies have increased their dividend payouts for 50 years, making them great for passive income. For example, Genuine Parts Company increased their payouts for 66 years in a row, and they have a sustainable payout ratio of 42%, or you have Illinois Tool Works, which many CPA experts predict will increase annual dividend payout to 5% per year.
So if you work at McDonalds and pay ordinary taxes for active income, but on the other hand, are smart and have dividends coming, you could start growing your portfolio income, have a balance between those taxes, and guess what? You’d pay zero taxes to capital gains on stock investments. And it’s completely legal.
Bottom line: Do not sell
One more rule for stockholders, do not sell under any circumstances. If you need something, borrow against it. When you sell, you pay taxes. When you don’t sell, you avoid capital gains on stock investments. Or, sell when it falls but buy it when the stock rises. Wealthy business people trade their stock they do not sell.
So if you have capital access, you can borrow against it. Which brings us to one more common term, ‘security line of credit.’ A security line of credit, also known as a SLOC, is a loan extended to a business or individual using the equity in their investment portfolio as collateral.
The SLOC allows the borrower to draw on the loan funds as needed, up to the maximum loan amount, and pay interest only on the amount used. This type of financing can be an attractive option for businesses or individuals who have a strong investment portfolio but need access to liquidity without having to sell their investments.
One of the key benefits of a SLOC is that it can help borrowers avoid liquidating their investments at unfavorable times or prices. In addition, you don’t pay tax when asking for a loan if you have billions of dollars in stocks.
That is why there is no secret recipe for finding stocks worth investing in. But one thing is certain; you can’t lose your money if you keep investing and stop selling. And that is Economics 101 – you have to keep the circle of money alive if you want to stay in that circle.
And before you exit, because this sounds like you need a lot of money, you must know that to avoid capital gains tax, you must have stocks in your possession because that will provide you options.
So there is a lot to learn about avoiding tax payments – legally. Just be sure to stay educated and partner with a CPA expert who can prepare you for the world of gaining wealth.