Investor Status

The IRS defines an investor as someone who typically buys and sells securities, and expects income from dividends, interest, or capital appreciation. IRS Pub 550 provides tax treatment guidance for investors. Income generated by investors, is for example, subject to the capital loss limitations in IRC Sec. 1211(b), and the wash sale rules outlined in Sec. 1091. Investors are permitted to deduct the expenses of producing taxable investment income as miscellaneous deductions, if those expenses exceed 2 percent of adjusted gross income (AGI).

Interest paid on money to buy or carry investment property that produces taxable income is also deductible, but under Sec. 163(d), the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible, but must be used to figure gain or loss upon disposition of the securities.

Investors are not eligible for tax trader status and cannot generally elect mark-to-market (MTM) accounting. However, investors can take advantage of a whole assortment of tax benefits that Congress have made available. I briefly touch on a few of these investor tax incentives in the pages that follow.

Capital Gains and Losses

When an investor sells a capital investment at a profit, he or she usually has to pay taxes on this profit. Selling within the first year of the investment, results in the investor paying tax at ordinary rates as high as 35 percent. Fortunately, for investors, the IRC encourages longer-term investments. By holding investments for at least a year (and one day) before selling, investors pay a lower rate — a maximum of 15 percent for most stocks, mutual funds, and other investments.

Investors also pay capital gains tax on some mutual fund distributions, even if they do not sell shares of the fund. It is important to note that when the fund sells some of its holdings, the taxable gains are passed on to investors.

Special rates apply on other types of investments such as futures contracts. As discussed in Chapter 5 of our Pro Trader Tax Guide, futures contracts are marked-to-market at the end of each tax year, with investors reporting these contracts as capital gains and losses on Form 6781: Gains and Losses from Section 1256 Contracts and Straddles. This allows them to split the gains and losses 60/40 on Schedule D (60 percent long-term/ 40 percent short-term), regardless of the holding period.

We all incur losses on investments eventually. Generally, capital losses are netted against capital gains. Up to $3,000 ($1,500 if married filing separately/MFS) of excess capital losses are deductible against ordinary income each year. Unused net capital losses are carried forward indefinitely and may offset capital gains, plus up to $3,000 ($1,500 if MFS) of ordinary income during each subsequent year.

Selling investments that have losses is a common technique late in the tax year. However, be careful of the 60 days-wash sale rules, which can take away your deduction, if you try to buy back what you’ve sold within 30 days.

Dividends

In addition to profits from selling investments, investors pay tax on any interest, dividends, or rental or other income they receive. Again, the IRC encourages some investments over others. Tax on qualified dividends on stocks and stock mutual funds are eligible for the same lower maximum 15 percent rate as long-term capital gains. In contrast, interest on bonds, income from rental property, and most other investment income typically is taxed at higher ordinary rates. One exception is interest from municipal bonds, which is tax-free on your federal returns and can offer state income-tax benefits as well.

Below is a table showing the various tax rates for capital gains and dividends depending on the taxpayer’s ordinary tax rate bracket.  You can see the preferential tax rates granted to investors for long-term capital gains and qualified dividends.

Table: 3.1 – Capital Gain and Dividend Tax Rates – 2009

* 50% (60% for certain businesses in empowerment zones) of the gain is excluded so the maximum effective rate is 14%.

** 90 days in the case of preferred stock.