So you made money on a short squeeze: What to do if you have massive capital gains on a stock
Your goal as an investor should be to make money, and you can do that in a number of ways. You can buy stocks that pay dividends and pocket that cash, or you can sell stocks at a share price that's higher than what you paid and bank the difference.
When you sell stocks at a profit, the result is capital gains -- and the IRS is definitely going to want a piece of those. As such, while sitting on a massive gain is a good problem to have in theory, because it means you've made a killing on a stock you owned, it could also pose a problem from a tax perspective.
Thankfully, there's an effective solution to this problem: a tactic known as tax loss harvesting. And if you use it strategically, your enormous gain may not be such an issue after all.
Negating gains with losses
The extent to which you'll be hit with a whopping tax bill on your capital gains will depend on how long you held your stock before selling it. If you held it for a year or less, you'll be subject to short-term capital gains taxes, and those can be expensive because they're the same marginal tax rate you'll pay on ordinary income.
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If you held your stock for at least a year and a day before selling it, the pain won't be as bad because you'll be bumped into the more favorable long-term capital gains category. Long-term capital gains taxes amount to 0% for low to moderate earners, 15% for moderate to high earners, and 20% for the very wealthy. These rates are much lower than ordinary income tax rates, so it generally pays to hold investments for at least a year and a day before selling them off, if that's possible.
Now, let's talk about how to negate some or all of those gains. The solution is simple: Sell underperforming stocks in your portfolio at a loss. Capital losses can be used to offset capital gains, so if you take a $6,000 loss and are sitting on $10,000 in gains, you'll only be subject to taxes on the remaining $4,000.
Keep in mind that capital losses are first applied to gains of the same nature. In other words, if you lock in a long-term capital loss, it will first be applied to your long-term capital gains, and then any amount left over will be applied to short-term gains. That's an important distinction, because it could impact the investments you choose to liquidate first.
Another thing you should know is that if you happen to have a major loss on your hands (enough to offset all of your capital gains and then some), you can use the remainder to offset up to $3,000 in ordinary income per tax year. And any remaining loss you have after that can be carried over to the next tax year.
Sell investments strategically
Having a large gain on your hands could mean that you chose your stocks wisely and sold at the right time, but it could also spell trouble from a tax perspective. Selling other investments at a loss is a good way to cancel out what could otherwise be a giant tax bill.
And if you don't have any investments to unload at a loss, prepare to pay estimated quarterly taxes on your gain during the year. Doing so will help you avoid being penalized by the IRS for underpaying your taxes.
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