Ask a Trainer: Why Do I Owe Taxes from Investing Even Though I've "Lost" Money?

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Editor’s note: Please be aware that we’re not tax professionals and this is not tax advice.

If you’ve been following the stock market, cryptocurrency, retail investing, NFTs and anything else related to investing/speculating, you may have experienced the roller coaster that was exuberance and then pessimism. From March 2020 to now, the stock market and the economy both went rapidly down, then rapidly up, kept going up and then began to gradually go down. These ups and downs are the result of the pandemic, social and civil unrest, political turbulence, wars, inflation, production chain issues, extreme weather conditions; the list goes on and on. All of these issues affect assets in one way or another and often come as surprises. And, that’s exactly what we want to talk to you about. Surprises. A common surprise that accompanied these fluctuations were the results and consequences of investing/speculating in the market.

Surprise: I owe(d) taxes but I didn’t make any cash/money from the stock market. Why is that? 

At The Financial Gym, one of our central pillars, and an ultimate absolute, is that every one of our clients has or works towards having a 3-to-6 month emergency fund. In short, an emergency fund is money that is easily and immediately accessible. This money is intended to be available for any urgent needs and worst case scenarios like helping you survive a job loss. In late 2020 and most of 2021, we encountered many people who felt that having cash in a high yield savings account for their emergency fund didn’t do enough. 

The common story was their money wasn’t working for them and they opted to invest in cryptocurrency, trade options, or buy stocks instead. Many made money and reinvested that money. Many also lost money and held on to what they bought hoping it would bounce back. Stocks and cryptos began to slide downwards and for those that hadn’t taken enough or any of their money out ahead of time had a big surprise waiting for them. When tax time (April 15th) came, many people found that they owed a lot of money in taxes but had nothing to show for it. 

Let’s focus on how that happened. When you buy a share of a company or token/coin of cryptocurrency, you’re buying something that is not cash, even though it is represented in dollar signs. Instead you’re buying something that constantly fluctuates up and down in price. When you sell that asset you have now either realized a gain or a loss. If you use that same money to buy something else and then sell that asset for a gain or a loss, that gain or loss gets added to your previous gain or loss. All the while as you’re buying and selling, you don’t realize that you’re racking up profits and losses. If you’re not careful, you could actually rack up a large tax bill and a large loss at the same time.

Scenario: Let’s use numbers to see what can happen

Imagine you invest $100 in one TFG stock on January 1st and then you sell that TFG stock on February 1st of the same year for $1,000. You have now realized a profit of $900 and recouped your original $100. Your account balance has now gone from $100 to $1,000 in a month. Amazing!

It’s still February 1st and you’ve decided you want to try again. This time you buy 10 shares (aka: stock) of ABC company for $100 each (a total of $1,000) and that stock also increases but this time to a value of $500 per share. Now you have $5,000, and after two months you decide to sell. Your account balance is now $5,000 and you made a profit of $4,000 and recouped your original $1,000. If you’re keeping track, you’ve actually recorded a profit of $900 and a profit of $4,000 for a total of $4,900. This is considered a realized gain.

Now it’s April 15th and you’ve identified company XYZ as your next money maker. Its shares are $500 each and you decide to buy 10 shares of XYZ using all $5,000 you have. This time around however, the stock price does not go up; instead it starts to go down and you keep holding on to it hoping it’ll go back up. It is now almost 12 months later and XYZ is now worth $10 per share and your total balance is back where you started, at $100. You’ve decided not to sell and you have a loss of $4,900 but because you have not sold, it’s considered an unrealized loss. This distinction is very important because now it’s tax time and as you’re doing your taxes your accountant tells you that you owe $1,500 in taxes. 

BUT HOW?! You ask your accountant how it’s possible you could owe $1,500 in taxes when you’re employer takes out taxes from your paycheck and you have no other form of income. The year before you had gotten a refund! 

Well, it turns out that because you had a realized gain of $4,900 (even though your investment account with 10 shares of XYZ company is still currently hovering around $100), you have to pay taxes on that profit, and to make matters worse, you’re paying more in taxes because your profit of $4,900 was added to your overall income/salary so you’re in a new tax bracket. 

• When investing there are two tax regimes:

  • If you buy and sell a stock within 365 days any money made will be taxed as ordinary income which is either 0%, 12%, 22%, 24%, 32%, 35%, 37% depending on your income (short-term capital gains)

  • If you buy and sell a stock on or after the 366th day then any money made will be taxed at capital gains which is either 0%, 15%, 20% depending on your income (long-term capital gains)

Final Thoughts

In the end, you made money and lost money in the market, but then “lost” money again because you had to pay $1,500 in taxes on a profit you never got to enjoy. At the time of this writing, the United States stock market is firmly in bear market territory and a new chorus of investing is happening: “buy the dip.” The scenario presented above happened to many people as they invested in (and sold) stocks, options, and cryptocurrencies when the market was flourishing. Many people thinking now is a great time to buy may find themselves in a similar situation sometime in the future. 

Purchasing individual stocks or other assets should be considered a hobby and you should consider using no more than 5% of your total assets to do this. But, more importantly, understand the consequences and tax implications involved. Speak with an accountant or CPA for a better understanding and be sure that you’re anticipating paying for taxes on any money you earn, from the stock market or otherwise.