Investment returns & taxes: What are your obligations?

Understanding investment returns

Before we examine tax implications, it’s vital that we gain an understanding of investment returns. When you use a forex broker like OANDA to invest in currency pairs, such as those traded via futures contracts or futures options trading, you’re speculating on their potential price movements while purchasing and selling price differences (minus fees or commissions) comprise your return on investment (ROI).

Foreign exchange trading (commonly referred to as FX or forex) trading stands out in its unique tax treatment. Within the U.S., forex traders may select one of two tax treatment options when taxed:

Section 988

Under this provision, Forex gains and losses are treated as ordinary income; that means any profits would be taxed as regular income. Conversely, if losses are incurred, you can claim them as ordinary losses, which offset other forms of income.

Section 1256

Manage tax on equities

Equities (stocks) represent ownership in a company. When you sell these shares at more than you paid for them, this results in capital gains, which fall under either category: (1) gains realized as part of an individual purchase transaction and (2) capital gains that occur as the result of investment sales transactions.

Short-term capital gains

Any profits realized after holding shares for less than one year before selling can be considered short-term capital gains and taxed at your ordinary income tax rate.

Long-term capital gains

Profits earned from stocks held for longer than one year fall under this category and enjoy a lower tax rate, depending on the individual’s income bracket.

Dividend and interest income are always welcome additions

Financial investments like stocks and bonds often yield dividends or interest that must be taxed according to your regular income rate; however, certain qualified dividends qualify for lower capital gains tax rates.

Tax-saving strategies for online traders

Tax-loss harvesting

Tax loss harvesting involves selling securities at a loss to offset gains made elsewhere, thus decreasing taxable income and helping lower a person’s taxes.

Hold investments longer

You may take advantage of a lower long-term capital gains tax rate by keeping investments for over one year.

Diversifying investments

Spreading your investments across several assets can help mitigate risks and potentially decrease taxable events.

Utilize tax-advantaged accounts

Consider investing through retirement accounts like an IRA or 401(k), which provide significant tax advantages when used correctly.

Complex derivatives and tax structure

Derivatives are financial instruments whose value derives from an underlying asset, such as stocks, bonds, or commodities. Common derivatives include options, futures, and swaps; however, their treatment is often complex for tax purposes.

Options

By buying options, you gain the right but not the obligation of buying or selling assets at predetermined prices within an agreed-upon timeframe. If an option expires, it’s considered a capital loss for that year of expiration; however, if exercised, it increases its cost basis, impacting future capital gains or losses upon the asset’s sale.

Futures contracts

Futures contracts obligate both buyers and sellers to buy or sell specified quantities at predetermined prices on a specified future date at a specific future price. Tax purposes dictate that futures contracts be marked-to-market at year’s end; that way, you report unrealized gains or losses as though you sold it then.

Swaps

Swaps are agreements between two parties to exchange cash flows or variables associated with different investments, with the tax treatment of swaps often depending on their nature and what asset is underpinning it.

Investment properties and their tax implications

Real estate can be an attractive way of investing. But before purchasing property for either rental income or capital appreciation, you must understand its tax implications.

Rental income

Any income generated from renting out property is considered taxable. However, deductions related to it — such as mortgage interest payments, property taxes, and maintenance — can help lower taxable liabilities.

Capital gains on sale

Capital gains are realized when you sell property for more than its adjusted cost basis (original purchase price plus improvements and depreciation minus depreciation). Long-term capital gains tax rates apply more favorably if the property was held over one year before the sale.

1031 exchange

Dubbed after Section 1031 of the United States Tax Code, this strategy allows investors to defer capital gains taxes upon selling an asset by investing it back in “like-kind” properties (i.e., investing into another similar property).

Tax implications of international investing

Due to online trading platforms, investing in foreign markets has never been more accessible. However, international investments present their own set of tax challenges.

Foreign tax credits

If your investment income was taxed abroad, then a Foreign Tax Credit in the U.S. might reduce your U.S. tax liability and provide some savings potential.

Passive Foreign Investment Companies (PFICs) are mutual funds or corporations located outside the U.S. that require U.S. investors to comply with stringent tax rules when investing. U.S. residents investing in PFICs can face reporting requirements that must be fulfilled. Therefore, U.S. investors should understand how reporting works for PFIC investments to stay compliant and avoid penalties from Uncle Sam.

Currency Fluctuations

Gains or losses caused by fluctuating foreign exchange rates can alter the U.S. dollar value of your investments and may result in tax consequences when selling them or receiving income.

Tax shelters

As the digital investment landscape changes, so too do strategies employed by experienced investors to maximize returns. One such tactic is using tax shelters — legal methods by which investors may reduce or defer their tax liabilities.

Conclusion

Understanding tax implications when online investing is as crucial as finding suitable assets. Financial success depends not solely on your earnings but on how you manage your earnings after deducting taxes. Investors can navigate their investment choices with greater ease and certainty by taking advantage of tax shelters, understanding international tax issues, and staying abreast of reforms. While strategies should generally be discussed openly, individual decisions must always be discussed with an accountant for the best outcomes tailored to specific personal situations.