Capital Gains
Unrealized
The term ‘unrealized’ describes the appreciation or decline in market value of a security during the holding period. At the time of sale, the unrealized gain or loss becomes realized (see below).
Realized
The term ‘realized’ describes the appreciation or decline in market value of a security from the time of purchase to the time of sale. Generally, the equation is Sale Price less Purchase Price less Cost of Sale. Realized gains and/or losses are taxable items unless the transaction occurred within a tax-deferred (401(k) or IRA) or tax-free account (Roth IRA).
Realized capital gains and losses are divided into 2 categories: Short Term and Long Term.
Short Term refers to the sale of a security within 12 months of purchase. Short term capital gains are taxed as Ordinary Income, subject to ordinary income tax brackets.
Long Term refers to the sale of a security sold more than 12 months after purchase. Long term capital gains are subject to the Long-Term Capital Gain tax brackets, which are 0%, 15%, and 20%, depending on total income and filing status.
Capital Gain Harvesting is a tax strategy to voluntarily sell securities to realize the capital gain before the end of the year. This may be especially advantageous when a taxpayer falls into the 0% Long Term Capital Gain tax bracket or has significant capital loss carryovers.
Capital Losses
Capital losses, whether short term or long term, are first used to offset any realized capital gains. If losses exceed gains, individuals can deduct up to $3,000 of losses from ordinary income. Losses more than the deduction are carried forward to offset future capital gains or ordinary income.
Capital Gain Distribution
Similar to individual investors, mutual funds actively buy and sell securities within the fund. This trading activity can result in capital gains or losses to the mutual fund. Unlike an individual investor, a mutual fund does not file an income tax return. Instead, the mutual fund distributes its earnings (interest, dividend, or capital gain) to its shareholders, who then pay the resulting income tax.
A Capital Gain Distribution is one such payment. It is a payment to an investor by a mutual fund resulting from the fund’s sale of stocks and other assets within its portfolio. Although Exchange Traded Funds (ETFs) may distribute capital gains, it is rare.
Mutual funds are required by law to regularly distribute capital gain to their shareholders. Unless the mutual fund is held within a tax-deferred or tax-free account, the investor must pay income tax on capital gain distributions, whether they are taken in cash or reinvested in the fund. This can be a surprise to investors, especially in a year of heavy trading by mutual funds.
Many funds publish their capital gain distribution payout per share amounts online. For example, Charles Schwab provides information on their website.
Capital gain distributions are typically paid sometime in December and are reported on Form 1099-DIV or Form 1099-Composite for income tax reporting. Investors typically receive these tax forms in late February.
The tax consequence of these unexpected distributions can be minimized by doing the following:
- Selling the security before the ex-distribution date. However, this may result in taxable capital gains if the security is sold at a gain.
- Owning ETF’s, which typically do not realize or distribute capital gains.
- Owning mutual funds within a tax-deferred or tax-free account.
- Harvesting tax losses before year-end.