Calculating taxes on stock sales

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Taxes on equity investment gains may seem inevitable. But understanding the rules for federal taxes on investments can give you the power to manage your tax liability more efficiently, even if you cannot avoid it. Here's an overview of some of the federal tax issues that an individual who buys and holds shares of stock in a taxable account might face.

Will the income be taxed at ordinary or long-term capital gains tax rates?

This may be the most fundamental tax question you could face with regard to investment-related income. Federal ordinary income tax rates generally apply to salaries, wages, professional fees, and interest, as well as gains realized from the sale of capital assets held for one year or less. Gains realized from the sale of capital assets held for more than one year are taxed at preferential long-term capital gain rates.
The tax rate on long-term capital gains is much lower than the tax rate on ordinary income (a maximum rate of 20% on most long-term capital gains, compared with a maximum rate of 37% on ordinary income not including the 3.8% for the net investment income). So timing your stock sales so that assets are held for more than one year so as to qualify as long-term capital gains might be a simple and important way to lower your federal income tax bill.

A simple case of investment tax accounting

Assuming that you bought a single block of stock in a company on a particular day, held it in a taxable account, and owned no other shares of the same company in the same account, tax accounting could be relatively straightforward. Your initial cost for the investment (the formal term is cost basis) would be your purchase price plus the commissions and fees you paid to affect the purchase. Your official purchase date would be the day your broker executed the trade (trade date), not the day you settled the trade and confirmed the payment for the shares (settlement date). Then, if you decided to sell that entire block in one trade, your sale proceeds would be the price at which you agreed to sell the shares less any commissions and fees you paid to affect the sale. Your official sale date would be the trade date of the sale (again, not the settlement date).
If you were to have sold the stock for more than your adjusted cost basis, you'd have a taxable gain; if less, a loss. If you owned the stock for more than one year (generally measured from the day after the trade date of the purchase to the trade date of the sale), you would quality for long-term capital gain tax rate. Otherwise, you'd report any gain as a short-term capital gain taxed at ordinary income rates for the year of the sale. If you were to have sold at a loss, you could use that capital loss to reduce any other capital gains you might have had. If the loss exceeded all of your capital gains for the year, you may be able to use any leftover amount (up to $3,000 per year) to reduce your ordinary income for the year. If there were any remaining capital losses after these steps, you could generally apply them to capital gains or income in future years, in what would be known as a capital loss carry forward.

Real life is usually not that simple

Many investors' positions include shares that were acquired on different dates and at different prices, perhaps due to multiple trades, dividend reinvestment programs, or the exercise of options, warrants, and incentives.
Assuming that you have complete records that show how, when, and at what cost each portion of your position was acquired, you have two choices when you figure your taxes.
One option allows you to assume that you sold the shares you've held on to the longest and use that price information for your cost basis in figuring your gain or loss. This is called first in, first out (FIFO); it is the default assumption when your broker reports your stock sale to the IRS.
The other option is called specific identification, which means choosing which block of shares in your position you use to figure your cost basis. Specific identification may offer you the potential to manage the size of any gain or loss you might realize in a particular trade. However, to be eligible to use specific identification at tax time, you must have instructed your broker about which shares you were selling at the time of the trade (no later than settlement day). Your broker should provide written confirmation of the specific identification in writing within a reasonable period of time after the sale.
Here are some other significant considerations involving capital gains tax accounting for stock positions:
  • If you do not have adequate records to assign specific prices to each portion of a stock position, the IRS requires you to use FIFO
  • If you receive identical shares at no cost as a stock dividend, a split, or a similar corporate action, you must adjust the cost basis on the position that generated the new shares proportionately
  • If you receive shares as part of an exchange, your cost basis normally includes the fair market value of the securities you exchanged
  • You cannot generally claim a loss for tax purposes on a trade if you had purchased or acquired in a taxable trade what the IRS calls "substantially similar" shares within 30 days before or after the trade that generated the loss. This is called a wash sale.
  • When you purchase new shares as the result of exercising rights or options, you will need to account for the rights' or options' value as well as the shares' value when determining gain or loss

What can you gain from choosing your cost basis?

If you want to trigger a relatively small immediate tax bill and you are considering only this sale, select the shares in the stock position that would produce the smallest possible gain when sold.
If you have a large gain elsewhere that you'd like to offset, consider selling any shares in the stock position that might have a losing cost base in order to generate a long-term loss. But remember that, even with an apparently losing position, the value of any immediate tax-loss harvesting should be balanced against the long-term potential of the company.
Finally, please keep in mind that this discussion is only a general guide. It may not address all of the factors relevant to your circumstances and needs. Seek professional tax advice before taking any action.

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