Owners and Loaners
To learn how different types of investments are taxed, we have to start with an understanding of what is — and what is not — an investment. In the broadest sense of the word, for instance, an education might reasonably be considered an investment in your future earnings potential. But for accountants, there are really only three basic types of investments: ownership, lending and cash equivalents.
Ownership includes investments in things like stocks, real estate and collectibles. Bonds and savings accounts are categorized as lending; the money you put into them is technically a loan to an entity like a city government or a bank, which pays you back with interest. Money market funds are cash equivalents because you can quickly and easily convert them into cold, hard cash.
When it comes to real estate, anybody who owns a house knows that local authorities levy property taxes to raise money for things like public schools, fire departments and road maintenance. Your income tax rate applies to rent earned from real estate, but if you sell property you're in the realm of capital gains (more on that below). Stocks are a little more complicated.
If you hold onto your stocks and they're paying dividends, the IRS would very much like a percentage (about 15 percent these days). If, however, you sell your stock, you have to pay a capital gains tax (maximum of 15 percent for most of us) on any profits you've made from it during the time you owned it. However, if you sell your stock less than a year after you bought it, the tax rate could be higher. The same goes for the sale of collectibles, houses, cars and pretty much anything you own, all of which the IRS calls "capital assets" [source: IRS].
Investments that fall under the category of lending are a little different. The interest generated by government bonds, for instance, is subject to federal taxes but not state or local ones. Corporate bondholders have to pay taxes at every level for any interest they receive, but municipal bonds are completely tax-free as long as you live in the state where they're issued.
You might have to pay taxes on cash equivalents like government treasury bills, corporate commercial paper or other investments that mature in less than three months. On the other hand, you might not. It all depends on the status of the investment. If you're storing your cabbage in treasury bills or commercial paper then, yes, the taxman cometh; however, your state and local government securities get off scot-free.
So when it comes to investments and how they're taxed, the old real-estate adage is applicable: It's all about location. Where your investments are held has a lot to do with their tax efficiency. And that's true in both financial and geographical terms.
But wait, what does this term "tax efficiency" mean? Keep reading to find out, and to discover the location of a small office building that's home to nearly 20,000 companies.