As you know, when you make a profit by selling something you’re expected to share the wealth. If the gain was from something you owned for one year or less, it’s considered short-term. If you held on for more than a year, it’s a long-term gain. Why does it matter? Because long-term gains are taxed at lower rates. It’s also important to note that gains and losses realized during the year are netted against each other before you’re taxed on them. Then the result is taxed as either profit or loss, long-term or short-term.

If this sounds confusing, that’s because it is. Nonetheless, you’re going to be making profits and losses, which means you should understand how they’re taxed. So let’s go over this in a bit more detail.

First, here’s how gains are taxed based on how long you own the asset.

Short-term gains: taxed like any other income you receive during the year.

Long-term gains: If your normal tax rate is lower than 20%, you pay 10%. If your normal tax rate is higher than 20%, you pay 20%.

I’ll briefly explain the process of netting out your short- and long-term gains, then tell you why it matters.

Say you get a 1099B in the mail that reveals a bunch of gains and losses, both short- and long-term. Step one is to net your short-term gains and short-term losses. Step two is to net your long-term gains and long-term losses. Step three is to net the results of both to arrive at a bottom line, which will be either short-term or long-term. Here’s an example.

Short-term gains for the year: $4,000

Short-term losses for the year: $5,000

Long-term gains for the year: $8,000

Long-term losses for the year: $5,000

Step One: Netting your short-term stuff leaves you with a $1,000 short-term loss.

Step Two: Netting your long-term stuff leaves you with a $3,000 long-term gain.

Step Three: Netting long-term and short-term leaves you with a $2,000 long-term gain.

So there you have it. A $2,000 net long-term gain. Since it’s long-term, it will be taxed at a maximum rate of 20%. But what if we’d ended up with a net loss? We could use it as a deduction against our income. But not more than $3,000 in any one year. In other words, while gains are fully taxable in the year you receive them, you can only deduct $3,000 of losses in the year you suffer them. Losses above $3,000 aren’t gone forever, however. You get to store them indefinitely until they’re used up. So losses in excess of $3,000 this year can be used next year or the year after or however long it takes to use them to either offset gains you make or income you receive. This is called a loss carryover.

Once you understand how gains and losses are characterized as short-term and long-term, how they’re netted against one another, how they’re taxed and how losses are carried over to subsequent years, you’re in a much better position to plan. For example, if I can wait a few days to convert a gain from short to long-term, I’d normally want to. If I’ve got a $5,000 loss carryover from last year, that means I can take $5,000 worth of gains this year without having to worry about paying taxes on them. Granted, this isn’t the simplest of stuff, especially when you start considering all the exceptions. (You can download Publication 544 from irs.gov to see what I mean.) But it’s not really rocket science, so it doesn’t hurt to brush up on the basics now and again.

Gambling Winnings

Winning money by gambling is just like making it any other way. In other words, difficult to do and totally taxable. The money you lose gambling, however, is only deductible against what you’ve won. So if you’re a net loser for the year, you’re out of luck both figuratively and literally. If you’re a net winner for the year, hopefully you’ve kept track of your gambling losses to partially offset that income. If you haven’t, drive out to the track and grab a bunch of losing tickets off the floor.

Alimony

Alimony is generally income for tax purposes and therefore taxable. A bummer if you’re receiving it, but righteous if you’re paying it, because alimony payments are deductible. Providing, you meet the list of requirements found in Form 504, viewable at irs.gov.

Child Support

Child support, also covered by Form 504, isn’t taxable income to the one getting it or deductible to the one paying it.

The deductibility of alimony and non-deductibility of child support could be of monster importance if there’s a divorce in your future. If you’re going to be faced with a big property settlement and/or child support payments, you’re better off as the payer of this stuff if it’s repackaged as alimony, since alimony is pretty much the only divorce-related money you’ll pay that’s deductible. (Attorney’s fees generally aren’t.) And making it deductible could ultimately save you 30% or more in income taxes. Of course, the amount you’ll pay in child support is often statutory, so it may be impossible to have it designated as alimony. In addition, the money you’re saving on taxes by paying alimony is money your ex-spouse is losing since they have to declare it as income and pay taxes on it. But think of the possibilities: you pay the ex-husband alimony, knowing that the schmuck will never report it as income. Let a couple of years go by...call the IRS with an anonymous tip...what fun!

Collecting Social Security

Used to be that Social Security retirement wasn’t taxable income. Then Congress decided that if your income was high, you should be taxed on at least part of your Social Security benefits. What’s considered high income? As of the 2002 tax year, it was $32,000 for joint taxpayers. And that income includes half of the Social Security benefits you received, and all of the interest income you received, whether or not it came from otherwise tax-free sources like municipal bonds. If your taxable income exceeds $32,000 ($25,000 if you’re single) you could pay taxes on half of your Social Security retirement, survivor and disability benefits...perhaps on even more than half. But since there’s not much you can do about it, and your tax-preparation software will figure it all out for you, there’s no reason to dwell on it. That’s just the way it is. If you feel like dwelling on it anyway, however, download Form 915 from irs.gov and dwell away.

Getting Rent Checks

Rental income is fully taxable. However, rental income can be offset by deductible rental expenses: see the chapter on real estate.

Income Summary

Now that we’ve covered the most likely sources of income you’ll be receiving, a pattern should be starting to develop. Basically, when it comes to taxes, pretty much every dime you ever see is taxable. To create tax deductions by losing or otherwise parting with money, on the other hand, often requires you to jump through hoops. Surprised?

Income Tax Deductions

You’ll recall from the beginning of this chapter that tax planning is all about timing. In other words, exactly when you’re forced to report money that’s taxable and exactly when you’re able to report money that’s deductible. You’ve just learned that most of the money you make is taxable, and that you’re pretty much forced to report it when it’s receivable. Now it’s time to learn that most of the money you spend isn’t deductible. But at least you have the flexibility to deduct allowable expenses in the year you pay them, which as you’ll soon see can be useful.

Before we continue, let’s be clear about what deductions are. A deduction represents money you’ve spent that ultimately serves to reduce your taxable income, which in turn reduces the amount of tax you owe. As such, deductions are highly desirable. But how can you tell which checks you write will qualify as deductions? Here’s a good rule of thumb: if the money you’re spending is putting a smile on your face, it’s probably not deductible.

Think I’m kidding? Take a look at the form you’ll use to report your itemized deductions, the infamous 1040 Schedule A. Here’s what you’ll find. First category of qualified deductions: medical and dental expenses. Next category: taxes paid. Then interest. Then gifts to charity. Then casualty and theft losses. Finally, job-related expenses.

Real barrel of monkeys, right?

Fact is, with the exception of gifts to qualified charities, the only checks you write that end up helping you deduction-wise are checks you have to write, not checks you want to write. But wait...it gets worse. Because even when you write these checks, you may still not end up with any deductions. Why? First, because the government figures most everyone will have some deductible expenses, so they allow us all a standard deduction. For married couples filing a joint return, that amount is around eight grand. For single people, around five. So unless you spent more than that on allowable deductions, there’s no point in keeping track of them. (At least not for federal tax purposes. If you pay state income taxes, these deductions may still be useful.) Second, even if you have a lot of deductions, Uncle Sam won’t let you take them if you make too much money. What’s too much money? If your adjusted gross income (total income minus a few things like IRA contributions, moving expenses, interest paid on student loans and alimony: you can see the complete list adjustments at the bottom of first page of a 1040 form) is in the neighborhood of $150,000 for joint filers, you start losing your deductions. Another way that Uncle Sam sticks a fork in rich folks.

All that being said, you should still keep an eye out for deductions, because despite their scarcity, they’re still better than a sharp stick in the eye. Let’s go back to our list from 1040 Schedule A and have a closer look.