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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. Sounds simple, 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
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.
BACK
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.
BACK
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
distributed, 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
distributes before trading mutual funds. If possible,
purchase funds after they distribute and sell funds
before the distribution date.
BACK
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:
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 38.6% 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
BACK
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
BACK
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:
- 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.
- 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.
BACK
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 expert or IRS Publication 550.
BACK
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 38.6%) 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.
BACK
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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