When you sell a stock for more than its purchase price, the profit you earn is never deductible from gross income. In fact, it has the opposite effect and increases your gross income. However, since the IRS treats all stocks that you own as capital assets, some of your profit may be subject to lower rates of tax depending on how long you owned the stock before selling it.
Capital Asset Overview
The federal tax law treats all property you own as capital assets, unless you use it in a business. This includes all personal property, such as your home and car, as well as your stock portfolio. Although the IRS doesn't allow you to deduct capital losses that result from the sale of personal property, you must always report the gains. For purposes of reporting gains, the IRS doesn't distinguish between personal and investment assets; rather it evaluates the holding period to determine the appropriate rate of tax.
Calculating Stock Profits
Calculating your profit from stock transactions requires you to ascertain the tax basis of each share. Your tax basis in the stocks is equal to the purchase price plus any commissions you pay. However, if you purchase the same stock at various times and prices, and later sell a portion of that portfolio, the IRS requires you to use a first-in, first-out approach to calculate the tax basis of the shares you sell. For example, if you sell 15 of the 20 shares of a stock, and paid $100 per share for the first 10 and $75 for the other 10, you must use the $100 basis for the first 10 shares and $75 for the remaining five. Calculating your profit simply requires you to subtract your tax basis in the stock you sell from the price you receive for them.
Gross Income Inclusion
If you have an obligation to report your stock transactions on a Schedule D form, you have no choice but to prepare your tax return on the long-form 1040. The Schedule D requires you to report each stock transaction separately, and to provide details on your profit calculation. When the net of all stock transactions results in overall profit, the form directs you to transfer the profit amount to the gross income section of your tax return. However, depending on your holding period, you may not have to pay ordinary income tax rates on the profit.
Assessing Holding Period
When you sell stocks at a profit, your holding period becomes important for purposes of reducing the rate of tax you will pay. The IRS refers to stock holding periods of one year or less as short-term, and holding period in excess of one year as long-term. The government likes to encourage investors to to engage in longer term investing, and as an incentive charges less tax on long-term investments than on short-term investments. Your long-term capital gains are subject to the capital gains tax rates, which are much lower than the ordinary tax rates you pay on your short-term gains as well as most other types of income you earn. However, there is no restriction on your ability to reduce your capital gains with both short and long-term losses.