How Is Equity Taxed? Stocks, Options, RSUs, and More

Equity represents ownership in an asset, most commonly a company. This ownership can take various forms, such as shares of stock, options, or restricted stock units. Holding equity offers opportunities for financial growth but also comes with various tax implications. Understanding these tax rules is important for managing financial obligations, as different equity types and transactions have specific tax treatments.

General Principles of Equity Taxation

When you sell equity, the difference between the selling price and your cost basis results in either a capital gain or a capital loss. A capital gain occurs when you sell an asset for more than you paid, while a capital loss happens when the selling price is less than your original cost. These gains and losses are categorized by how long you held the asset.

The distinction between short-term and long-term capital gains is important for tax purposes. Short-term capital gains arise from the sale of assets held for one year or less, taxed at your ordinary income tax rates (10% to 37% for 2024). Profits from assets held for more than one year are long-term capital gains, which typically receive more favorable tax treatment.

For the 2024 tax year, long-term capital gains are taxed at 0%, 15%, or 20%, depending on your taxable income. Individuals with lower taxable incomes (e.g., up to $47,025 for single filers or $94,050 for married filing jointly) may qualify for a 0% rate. A 15% rate applies to middle-income earners, while the 20% rate is for higher taxable incomes exceeding thresholds (e.g., $518,900 for single filers or $583,750 for married filing jointly).

Beyond capital gains, dividends received from equity investments are also subject to specific tax rules. Dividends are distributions of a company’s earnings to its shareholders. For tax purposes, dividends are generally classified as “qualified” or “non-qualified” (ordinary) dividends.

Qualified dividends are eligible for the same preferential tax rates as long-term capital gains (0%, 15%, or 20%) for the 2024 tax year. To be considered qualified, dividends must be paid by a U.S. corporation or a qualifying foreign corporation. The stock must be held for a specific period around the ex-dividend date, typically more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

Non-qualified dividends do not meet the criteria for qualified treatment and are taxed at your ordinary income tax rates, similar to short-term capital gains. This means non-qualified dividends can be taxed at rates up to 37% for the 2024 tax year. Most dividends from real estate investment trusts (REITs), money market accounts, or employee stock options generally fall into the non-qualified category.

Cost basis is fundamental to calculating both capital gains and losses. Your cost basis is generally the original price you paid for an asset, plus any commissions or fees incurred to acquire it. It serves as the benchmark against which the selling price is measured to determine your taxable gain or deductible loss.

Taxation of Publicly Traded Stock and Dividends

Investing in publicly traded stock involves several tax considerations. When you buy shares, there is no immediate tax event. The purchase establishes your initial cost basis, which is the amount you paid for the shares, including any brokerage commissions.

Dividends received from publicly traded companies are taxed based on their classification as qualified or non-qualified, as discussed previously. Qualified dividends are taxed at the lower long-term capital gains rates (0%, 15%, or 20% for 2024), provided specific holding period requirements are met. Non-qualified dividends are taxed at your ordinary income tax rates, which can be as high as 37% for 2024. Your brokerage firm typically provides Form 1099-DIV, detailing dividend types and amounts.

The primary tax event for publicly traded stock occurs when you sell your shares. You realize either a capital gain or a capital loss, calculated as the difference between the sale proceeds and your cost basis. If you held the stock for one year or less, any profit is a short-term capital gain, taxed at ordinary income rates. If held for more than one year, any profit is a long-term capital gain, subject to the more favorable 0%, 15%, or 20% capital gains rates.

If you sell shares for a loss, that capital loss can offset capital gains. If your capital losses exceed your capital gains, you can deduct up to $3,000 of net capital losses against your ordinary income ($1,500 if married filing separately). Any remaining capital loss can be carried forward indefinitely to offset future capital gains or a limited amount of ordinary income. Brokerage firms report sales transactions on Form 1099-B, providing proceeds and, for covered securities, the cost basis.

Taxation of Employee Stock Compensation

Employee stock compensation, such as stock options and restricted stock units (RSUs), introduces unique tax complexities. Tax implications depend on the specific compensation type, with tax events occurring at grant, exercise, vesting, and sale.

Non-qualified stock options (NSOs) do not trigger a taxable event at grant. The primary tax event occurs when the employee exercises the options. At exercise, the difference between the fair market value of the stock and the exercise price (the “bargain element”) is taxed as ordinary income. This amount is included in the employee’s wages and is subject to withholding and payroll taxes.

After exercising NSOs, the employee owns the shares, and their cost basis is the fair market value on the exercise date. If the employee later sells these shares, any difference between the sale price and this adjusted cost basis results in a capital gain or loss. This gain or loss is short-term if held for one year or less after exercise, or long-term if held for more than one year. The holding period for capital gains begins the day after the exercise date.

Incentive stock options (ISOs) generally offer more favorable tax treatment than NSOs. There is no regular income tax due at grant or exercise. However, the bargain element for ISOs may be subject to the Alternative Minimum Tax (AMT) in the year of exercise, potentially resulting in a tax liability.

To qualify for favorable long-term capital gains treatment upon sale (a “qualified disposition”), ISO shares must be held for at least two years from the grant date and one year from the exercise date. If these holding periods are met, the entire gain is taxed as a long-term capital gain. If sold before meeting these periods (a “disqualified disposition”), the bargain element at exercise is taxed as ordinary income, and any additional gain or loss is treated as a capital gain or loss.

Restricted Stock Units (RSUs) have no taxable event when granted. The tax event occurs when RSUs vest, and the employee takes ownership of the shares. At vesting, the fair market value of the shares on the vesting date is taxed as ordinary income. This amount is added to the employee’s wages and is subject to withholding and payroll taxes.

Once RSUs vest, the fair market value at vesting becomes the cost basis for those shares. If the employee later sells the vested shares, any difference between the sale price and this cost basis results in a capital gain or loss. This gain or loss is short-term if held for one year or less after vesting, or long-term if held for more than one year. The holding period for capital gains begins on the vesting date.

Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock, often at a discount. The discount element, which is the difference between the fair market value and the discounted purchase price, is generally taxed as ordinary income.

If ESPP shares are held for at least two years from the offering date and one year from the purchase date, the discount is treated as ordinary income, and any additional profit upon sale is a long-term capital gain. If sold before meeting these holding periods, a portion or all of the discount might be treated as ordinary income, and the remaining gain or loss would be a short-term capital gain or loss. The cost basis for ESPP shares includes the discounted purchase price plus any ordinary income recognized on the discount.

Calculating and Tracking Your Cost Basis

Accurately calculating and tracking your cost basis is important for proper tax reporting. Your cost basis is the amount invested in an asset, which reduces taxable capital gains or increases deductible capital losses. Incorrect basis can lead to overpaying taxes or under-reporting losses.

For basic stock purchases, your cost basis is typically the purchase price plus any commissions or fees. For other equity types, cost basis determination can be more complex. For Non-qualified Stock Options (NSOs), your cost basis is the exercise price paid plus the ordinary income recognized at exercise. For Restricted Stock Units (RSUs), it is the fair market value on the vesting date. For Employee Stock Purchase Plans (ESPPs), it includes the discounted purchase price plus any ordinary income recognized from the discount.

Various events can affect your cost basis, requiring adjustments. Stock splits divide shares, proportionally reducing the cost basis per share while keeping the total basis unchanged. Reinvested dividends increase your total cost basis. Return of capital distributions reduce your cost basis.

Maintaining records is important for tracking cost basis. Brokerage statements, especially Form 1099-B, report sales proceeds and, for “covered securities,” the cost basis and acquisition date. For “non-covered securities” or complex transactions, the cost basis on Form 1099-B might be zero or incorrect, requiring self-calculation. Retaining transaction confirmations, exercise notices, and vesting statements is therefore important.

A common pitfall is the “wash sale” rule, which prevents claiming a loss on a security sale if a “substantially identical” security is purchased within 30 days before or after the sale (a 61-day window). If a wash sale occurs, the disallowed loss is added to the cost basis of the newly acquired shares, deferring the loss until the new shares are sold.