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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:
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:
Resulting Current Holdings:
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:
Resulting Current Holdings:
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
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Maintain your original holding period
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Decrease your cost per share
Common mistakes shareholders make when updating for stock
splits:
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
20%.
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'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 $29.375
$29,375.00
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
BACK
Updating positions for Spin-offs
A spin-off is a 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 $10,000 gift exclusion. In short,
the recipient of a gift does not pay a gift tax on any gift valued at
$10,000 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. But if you have been a member of GainsKeeper and
recorded this stock in GainsTracker, this has been done automatically for
you.
What's your Taxable
Gain on Stocks Received as a Gift?
Figuring out your
cost basis:
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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 20% tax rate.
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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 $10,000, 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 20% 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 20%, 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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