Understanding the Basics of Investment Taxation and Optimizing Your Returns

Here are a few tax implications to consider as you dive into investing.

A man sits on the floor in front of the sofa where a woman sits as they look at a laptop and paperwork together.
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Taxes are never a fun thing to consider. For someone who has a couple of W-2 forms and maybe a child tax deduction or two, they’re an inconvenience. For someone who has investment income, tax planning and return preparation can seem like a never-ending headache. It’s especially brutal when you don’t understand how the numbers interact with each other or where you can find ways to reduce taxes.

Knowing the basics of investment taxation goes a long way toward being able to navigate your tax obligations and find opportunities for savings. Here are a few tax implications to consider as you dive into investing.

Capital gains vs ordinary income

Whether you’re investing in real estate or the stock market, the goal is to make money. That can come in the form of rental income that hits your account on a monthly basis or selling an asset at a profit. As long as you report it on your tax return, you might think you’re good — money is money, right? Unfortunately, it’s not that simple.

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Especially when it comes to investment taxation, income may not just go into one tidy bucket. One of the most important basic tax considerations to understand is the difference between capital gains and ordinary income.

Capital gains tax typically applies to income from the sale of assets that have been held for at least a year. For example, let’s say you sell some stock. If you have held that stock for at least a year, the most you will pay in taxes is 20%. If you purchased the stock less than a year ago, the net sale proceeds will be taxed as ordinary income. Ordinary income tax rates are typically higher than capital gains tax and can be as high as 37%.

To make matters more complicated, you can’t use losses from one type of income to directly offset profits from the other. Let’s say a real estate company with multiple properties has a loss for the year but sells a property for a profit of $200,000. If the property sold was owned for at least a year, the sale price minus basis would be considered a capital gain. The business may have taken a loss on its ordinary rental income, but those losses can’t be applied against the capital gain.  

So if you know you’re in for a big capital gain, racking up expenses won’t offset taxes the way it would against ordinary income. Knowing the difference between capital gains and ordinary income is key when you’re trying to minimize your tax bill.

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Take advantage of tax incentives

Speaking of minimizing your tax bill, you can often optimize your tax return by taking advantage of tax incentives. As a matter of policy, governments try to encourage cash flow into certain economic sectors and regions. Oftentimes that’s accomplished by offering tax deductions and credits for certain investments.

For example, energy efficiency has been strongly encouraged through federal tax incentives such as the 179D deduction. If you’re involved in commercial real estate investment, this could be hugely beneficial if you’re building or remodeling a commercial building. 

When the credit was first introduced in 2005, there was a maximum credit of $1.80 per square foot. In 2022, Congress passed the Inflation Reduction Act and expanded the program. If your building meets the program’s requirements, you could be looking at a maximum deduction of $5 per square foot. 

So if you’re remodeling your 30,000-square-foot building, you could theoretically get up to a $150,000 deduction. It would require your remodeling plans to meet the deduction’s requirements, but those changes could be worth the tax savings. 

There are hundreds of tax incentives out there to investigate. Some are state-specific, while others have been enacted at the federal level. If you’re just getting started, you can consider actions you were going to take anyway and see what incentives are available to mitigate tax ramifications. If you’re going to have a large capital gain, for example, research qualified opportunity zone credits. Or if your Missouri-based real estate business will donate to charity, consider choosing a Neighborhood Assistance Program-eligible organization to increase savings.    

Know your thresholds and timelines

In the tax world, different rules apply depending on how much money you make or how long you’ve owned something. There are also all sorts of deadlines to consider after an asset sale is completed.

One example of a threshold to consider is net investment income tax. It’s a sneaky little 3.8% tax that comes into play based on the combination of your modified annual gross income and investment income. Basically, any investment income that goes over the threshold for your filing status gets an extra 3.8% tacked on. Knowing that threshold can help you identify opportunities where you could potentially lower your MAGI to slide in under that limit.

Deadlines and sale dates can be important, particularly so in real estate. If you have invested in real estate and sell a property at a profit, you could be looking at capital gains tax. However, there is a way to defer those gains by purchasing a similar property with the proceeds. This is called a “like-kind” exchange, or Section 1031 exchange

To qualify, you need to identify the like-kind property within 45 days of the sale. You’ll also need to complete the property transfer within 180 days or the tax return deadline for the year in question. Miss those deadlines and you could miss out on tax savings.

Understand the basics, reap the benefits

It can be hard to wrap your brain around investment taxes if you don’t know what to look for and how various aspects of the tax code interact. By understanding the basics of investment taxation, you can better interpret your tax liabilities and assess your strategies. That confidence can lead to smarter investing and a healthier bottom line to support the lifestyle you want.



The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Justin Donald

Justin Donald, Founder of The Lifestyle Investor, helps entrepreneurs and business executives invest to create passive income and freedom.