Tax Education Center


All investors need a basic understanding of fundamental investment tax issues, especially calculating your cost basis. To calculate cost basis you need to track investments by the individual tax-lot, instead of by aggregate holdings. Only by tracking original cost and the original purchase date can you accurate calculate your gains and losses. Whether you choose to prepare your own taxes or hire an accountant, you should understand how to calculate your cost basis as well as the following tips:

Selling methodologies
Holding Period Analysis
Cost Basis Calculations
Mutual Fund Distributions
Updating positions for Stock Splits
Updating positions for Mergers
Updating positions for Spin-offs
Gifting stocks
Transferring assets

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Selling methodologies

Every time you purchase a new stock, you create another holding/position in your portfolio. If you sell all the shares in one of these positions, you exit the position. The sell transaction results in either a capital gain or capital loss. Simple enough, right?

However, the process becomes more complicated if you have multiple lots of the same security. A "lot" is created when you instruct your brokerage to purchase a security. For example, you used your online broker to purchase 100 shares of MSFT on 1/1/99, you created a lot in MSFT. Then on 3/1/99 you purchase 50 shares of MSFT, without selling your original lot of MSFT created on 1/1/99. Now you have two lots of MSFT. Since these two lots were purchased at different times and probably at different prices, you must record the lots separately for accurate capital gain/loss determination. Even if you purchase two lots on the same day (and even with the same price) you must track these lots separately for tax reporting.

For example:

  • Buy 1/1/99 100 shares of MSFT
  • Buy 3/1/99 50 shares of MSFT

Sell by FIFO Method:
Now, on 4/1/99, you instruct your brokerage to sell 50 shares of MSFT without specifying which lot you want to sell from. Your broker will automatically default to First-in-First-out (FIFO) accounting, and sell the 50 shares from the first lot of MSFT you purchases, the 1/1/99 lot. The following is the result of FIFO selling:

  • Buy 1/1/99 100 shares of MSFT
  • Buy 3/1/99 50 shares of MSFT
  • Sell 4/1/99 50 shares of MSFT

Resulting Current Holdings:

  • 1/1/99 50 shares remaining of MSFT
  • 3/1/99 50 shares of MSFT

Impact of FIFO? There is nothing wrong with FIFO methodology, but it doesn't allow the tax payer to control how much gain or loss is recognized as taxable by the IRS. FIFO sells your oldest lots first, which in a rising market have the lowest cost, but the highest gain.

Sell by Specific ID Method: This method requires that you designate which shares you would like to sell. In order for the IRS to recognize a Specific ID sell, you must at the time of the sell transaction tell your broker which shares to sell by referencing the purchase date and purchase price. Your broker must then respond to you with a written confirmation of these instructions. This means you can not decide during year-end tax preparation which lots were sold by Specific ID. You must specify a Specific ID sell method at the time of the sell transaction. If you don't, the sell must be considered a FIFO sell.

For Example:

  • Buy 1/1/99 100 shares of MSFT
  • Buy 3/1/99 50 shares of MSFT
  • Sell 4/1/99 50 shares of MSFT (by Specific ID on 3/1/99 lot)

Resulting Current Holdings:

  • 1/1/99 100 shares of MSFT (original lot)

When should I use the Specific ID sell method?
It is possible to reduce the taxes you have to pay the TaxMan by selling your highest cost shares first. Better yet, sell a lot that has a loss, so that you can offset a gain you realized on a prior sale. In the above example, if on 4/1/99 you were looking to sell 50 shares of MSFT, you must first determine if you have any realized capital gains that you can offset with a loss. If you have a capital gain, then determine if it is characterized as a long-term or a short-term gain.

Let's imagine that in the example above a sell of 50 shares from the 1/1/99 lot would result in a small short-term capital gain, while a sell of 50 shares from the 3/1/99 lot would result in a large short-term capital loss. Furthermore, let's imagine you recognized a short-term capital gain from a different sale. In this case, it is tax efficient to sell the most recent lot of MSFT, 3/1/99, for a loss and use this loss to offset your short-term gain. Remember that if you don't instruct your broker to sell by Specific ID on 3/1/99, FIFO will be used by default and you will be unable to offset this gain on your Federal tax return.

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Mutual Funds (Average Cost Selling)

Two other sell methodologies that are only applicable for Mutual Funds are Single Category Average Cost and Multiple Category Average Cost. Using the Single Category method you add up the cost of all your shares and divide that by the number of shares. This is the cost per share used to calculate a gain or loss.

With the Multiple Cost method, investors need to average the cost of all their long term shares and their short-term shares separately. When selling shares an investor needs to identify whether they are selling long or short-term shares and use the appropriate cost calculation.

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Mutual Fund Distributions

Numerous investors buy Mutual Funds with the intention of holding long-term. They are surprised to find out that they may owe capital gains taxes, if the funds paid distributions, even though they did not sell any shares. Mutual funds, by law, must distribute capital gains and income back to shareholders. Unfortunately, they pass these distributions to all shareholders on record date; this is not necessarily the same group of shareholders who held the mutual fund when it generated the gains. As a general rule, investors should find out when the fund makes these distributions before purchasing the mutual fund. If possible, purchase funds after they distribute and sell funds before the distribution date.

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Updating positions for Stock Splits

A stock split is an increase in the number of shares outstanding of a company without any change in the shareholder's equity or market value. To properly account for a stock split:

  • Increase your position by the stock split rate on Ex Date
  • Maintain your original total cost
  • Maintain your original holding period
  • Decrease your cost per share

Common mistakes shareholders make when updating for stock splits:

  • Add the new shares with zero cost basis - creating 100% gain when you sell these shares
  • Set the Ex date as the acquisition date - creating an inaccurate holding period

Both of these errors can have significant impacts on the taxes you pay. First you are creating a huge gain and because you used an incorrect acquisition date, you may create a short term gain, taxed at your ordinary income rate, as high as 35% instead of a long term gain, taxed at 15%.

Here is an example to illustrate the proper accounting of stock splits:

On 5/3/00, EMC announced a 2 for 1 stock split. Ex Date is 6/5/00, set by the NYSE.

Bill Smith's position in EMC prior to the stock split is:

Acquisition Date

Shares

Cost Per Share

Total Cost

1/15/99

100

$24.25

$2,425.00

5/18/99

250

$26.50

$6,625.00

2/10/00

500

$58.75

$29,375.00

Bill Smith's position on Ex Date:

Acquisition Date

Shares

Cost Per Share

Total Cost

1/15/99

200

$12.125

$2,425.00

5/18/99

500

$13.25

$6,625.00

2/10/00

1000

$29.325

$29,375.00

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Updating positions for Mergers

A merger is a combination of two or more companies. When updating your positions for mergers, please note the following information:

  • Calculate the shares you will receive of the new company by using the finalized merger rate
  • Read your prospectus to find out if the merger is taxable or non-taxable to shareholders -this information is necessary for determining your new cost basis and holding period

Common mistakes shareholders make when updating for mergers:

  • Incorrect determination of the tax status of the merger - impacts the cost basis and holding period-without accurate cost basis and holding period information, you will have inaccurate gain/loss figures when you sell the shares
  • Assumption that the original cost basis and holding period will transfer to the new shares received -if the merger is taxable you will be taxed on the full value of the merger and you will need to calculate your new cost basis and holding period for your new shares

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Updating positions for Spin-offs

A spin-off is a corporate disposition of a subsidiary or division of the company. When updating your positions for a spin-off please note the following information:

  • Maintain your shares and holding period of the parent company
  • Calculate the shares you will receive of the spun off company by using the finalized rate of distribution
  • Read your prospectus to find out if the spin-off is taxable or non-taxable to shareholders -this information is necessary for determining your new cost basis and holding period

Common mistakes shareholders make when updating for spin-offs:

  • Incorrect determination of the tax status of the spin-off - impacts the cost basis and holding period -without accurate cost basis and holding period information, you will have inaccurate gain/loss figures when you sell the shares of the parent company and/or the spun off company
  • Add the new shares with zero cost basis - creating 100% gain when you sell these shares

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Gifting stocks

Let's clarify the U.S. tax code concerning the $11,000 gift exclusion. In short, the recipient of a gift does not pay a gift tax on any gift valued at $11,000 or less. No matter if it is a boat, car, cash or stock. Not so fast! This means you don't owe taxes at the time of the gift of a stock, but when the recipient sells the stock, it is a taxable event. Like everything else related to investing and taxes, a correct cost basis is the key to resolving how much you owe when you sell a stock received either as a gift or through inheritance. A local library's microfilm archive might be the best resource to find the value of shares on a particular date and determine your cost basis, but be cautious about stock splits and other corporate actions! Tax advisors suggest to consult the S&P stock guide, the Value Line Investment Survey, or the company that issued the shares for a history of the stock price, stock splits and other capital changes.

What's your Taxable Gain on Stocks Received as a Gift?

Figuring out your cost basis:

  • If you sell the shares for a gain, use the donor's cost basis and purchase date as your cost basis and purchase/acquisition date to characterize your realized capital gain. In other words, if your donor bought the gifted stock over a year ago from the time you sell the stock, it can be considered a long-term gain - maximum of a 15% tax rate.
  • If you sell the shares for a loss, your cost basis is the lower of: (1) the donor's basis or (2) the Fair Market Value (FMV) as of the transfer date. Your purchase/acquisition date will be the donor's purchase date in case (1) or the transfer date in case (2). We can thank Congress for this rule; they feel people should be prevented from giving away a loss.

Note: If the donor paid a gift tax on shares given to you with a value over $11,000, you should adjust the cost basis determined above. In the simplest case, adjust it upward by the amount equal to the gift tax. Specifically, the gift tax amount attributable to the stock appreciation before the date of the gift.

What's your Taxable Gain on Stocks Received through Inheritance?

Determining your taxable gain on inherited stocks is more straight forward than with gifted stocks. To figure out your cost basis simply set the Fair Market Value (FMV) of the stock on the date of your benefactor's death to your new cost basis. Use the average of the high and low prices of the stock on that date as the FMV. Your holding period is always considered long-term and qualifies for the 15% maximum tax rate. Remember, when filing your Schedule D, enter "inherited" in the space marked for the acquisition date for this stock. That way, the IRS won't confuse your holding period with the date you received the stock.

If you want to give a stock away as a gift, always gift the particular lots with lowest cost basis and short-term (if possible) - keeping the higher cost, longer-term lots. In your portfolio, look at the "Unrealized Views" to identify the best lot to gift.

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Transferring assets

No gain or loss is recognized if you transfer assets within your account or to a spousal account. The holding period and original cost basis remains intact. Transferring ownership to other parties or entities is considered a gift. There are additional tax implications if you are transferring assets to related family members. Please consult a tax advisor or IRS Publication 550.

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Holding Periods

Long-term gains are defined as securities held for more than a year. Short-term gains are defined as securities held a year or less. Since short-term gains are taxed at your income rate (possibly as high as 35%) and long-term gains are taxed at a fixed 15%, it is tax efficient to sell for a gain after you have held a stock for more than a year (long-term) and sell for a loss when you have held a stock for a year or less (short-term). Smart investors will try to offset all short-term gains with short-term losses before year's end. In addition, after you offset all your capital gains, you can use any remaining losses to offset as much as $3,000 in ordinary income.

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Cost Basis Calculations

Calculating cost basis is the foundation of tax-lot accounting. To accurately calculate your cost basis you need to track your holdings by the individual tax-lot and not your aggregate holdings. Only by tracking original cost and purchase date can you accurately calculate gains or losses when you sell securities. Cost basis can be adjusted for corporate actions or wash sales - you should familiarize yourself with both to ensure accurate cost basis.

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