Breaking Even: Short-term vs. Long-Term Capital Gains
So here you are six months after buying that old-new economy, click-n-brick, mid-cap, high-tech stock; or perhaps it was a new-old economy, large-cap, multi-national, conglomerate, low-tech stock. Let’s say your stock has jumped 20 percent in seven months, a gain you expected to take twice as long. You’ve made a healthy gain and you’re wondering what you should do now.
To sell or not to sell?
If you sell a stock you’ve held for less than a year and a day, your profit will be subject to your regular income tax — often higher than the 20 percent long-term capital-gains tax.
To sell or not to sell?
Perhaps you think the stock has become overvalued at this point and you should cash in your chips and brag about your smart investment in the office tomorrow while sipping your grande mocha latte. Perhaps you believe that a sector or industry will experience an economic slowdown over the next few quarters and you should get out of Dodge while the getting is good.
Maybe you believe that Mr. Greenspan & Co. will continue to tighten the vise on the economy. Or maybe you think the stock will simply meander for the next few months and better opportunities to invest your newfound gains await you. Regardless of the reason why, you’re squirming around in your chair deliberating whether you should sell and take a short-term gain or wait it out for a full year and get the tax break of a long-term gain.
The break-even point
The take-home profit you’ll see by selling a stock for a certain amount in the short term will be the same as what you’ll realize by selling at a lower price in the long term. Calculating that “break-even” point may be complicated, but it’s not impossible.
To do so, you’ll need to know your federal and state ordinary income tax brackets (for short-term gains) and your federal and state long-term capital gains rates (check with your tax advisor or the IRS and your state tax board). Take the value of your net gain after taxes, divide it by the inverse of the combination of federal and state long-term capital gains rates, divide this by 100, and add that to your original purchase price per share.
Sound like Greek?
Here’s a formula that you can plug into a spreadsheet, which will give you the bottom line:
PRo=Original purchase price
Fs=Federal tax bracket (short-term gains)
Ss=State tax bracket (short-term gains)
Fl=Federal long-term capital gains rate
Sl=State long-term capital gains rate
The BE will be equal to:
Calculating your break-even point
Suppose you purchased 100 shares of XYZ at $50 per share seven months ago for a cost basis of $5,000 (excluding commissions) and it is currently trading at $60 per share, giving you a 20 percent gain in seven months. If you sell now and take a $1,000 gain, you’ll have to pay short-term capital gains rates on your federal and state personal income-tax returns. If you wait to sell until you have held the stock for a year, how low can you sell to realize the same take-home profit?
The answer, of course, depends on a particular person’s federal and state tax brackets. As an example, let’s assume your federal bracket for ordinary income tax is 36 percent and your state bracket is eight percent, and that the federal long-term capital gains rate is 20 percent and the state long-term capital gains rate is eight percent. By selling at $60 per share and realizing a $1,000 short-term gain, you will owe $360 in federal taxes and $80 in state taxes, reducing your net gain to $560.
What can you sell the stock for in the long term to realize the same take-home gain?
In this case,
BE = 50 + ((((100*60)-(100*50))-(((100*60)-(100*50))*(0.36+0.08)))/(1-(0.20+0.08))/100)
= 50 + (((6000-5000)-((6000-5000)*0.44))/(1-0.28))/100)
= 50 + ((1000-(1000*0.44))/0.72/100)
= 50 + ((1000-440)/0.72/100)
= 50 + (560/0.72/100)
= 50 + (777.78/100)
= 50 + 7.78
If you hold the stock for longer than a year and a day, you’ll be able to afford to sell the stock at $57.78 per share. That’s your break-even price. At $57.78 per share, you’ll realize a long-term gain of $777.78, on which you will pay $155.56 in federal capital gains taxes and $62.22 in state taxes. Your net gain will still be $560. Again, this does not take into account commissions paid.
The answer to the question
Only you can decide how to answer the question of whether or not to sell. Keep in mind that you should always assess whether selling at a certain point fits into your broader investment strategies. While making such calculations can take some of the guesswork out of a decision on when to sell, it’s always wise to check with your financial or tax advisor about tax implications.
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