Taxation Issues - Calculating Gains and Losses

Cost Basis
A key concept to understand in computing gains and losses is cost basis, since the amount of capital gains to be taxed is calculated by subtracting the investor's cost from the sales proceeds. To determine the cost basis of an investment, start with the original price (plus any transaction costs). Next, add the dollar value of dividends that were reinvested. This would apply to both stocks in a dividend-reinvestment program and mutual funds where dividends are automatically reinvested. Reinvested capital gains are also added to the cost basis for mutual funds.
If you inherit an investment, your cost basis is the value of the asset as of the decedent's date of death. This is known as a stepped-up cost basis. Also, the holding period is always considered long-term, even if the deceased hadn't owned the investment for 12 months before death.

If you receive an investment as a gift, there are actually two different cost bases that apply: the actual cost basis of the giver and the market value on the date of the gift. The best way to explain how this works is to use an example. Let's say you are given shares of a mutual fund, and the original owner's cost basis was $70 a share. On the date of the gift, the shares are trading at $60. If you sell the shares in the future, the basis for a gain is $70 a share, and the basis for a loss is $60. If you sell the shares for a price between $60 and $70, you have neither a taxable gain nor a taxable loss.

Netting Capital Gains and Losses
If an investor makes a number of trades in a particular year, the end result could be a mix of long-term and short-term capital gains and capital losses. The IRS is specific as to how these gains and losses are to be netted against each other. Here are the steps:

  • Net short-term gains against short-term losses
  • Net long-term gains against long-term losses.
  • If both holding periods result in gains (or both in losses), they are reported separately on Schedule D.
  • If one holding period results in a gain and the other in a loss, they are then netted against each other.
  • If capital losses exceed capital gains, up to $3,000 can be deducted against ordinary income in any one year.
  • Unused capital losses can be carried forward indefinitely to future years - each year, unused capital losses will first be netted against the current year's capital gains, followed by the $3,000 deduction against ordinary income.

There are a number of occasions that may result in an investor moving shares of one mutual fund to another. If done within the same mutual fund family, this is known as an exchange. From the investor's point of view, a sale has not occurred - but the IRS does consider this a sale. Therefore, capital gains must be calculated and taxes paid. As a result, the cost basis in the new shares is simply the net asset value of the shares that were purchased.

Wash Sales
If you own mutual fund shares (or other securities) that have gone down in value, but you believe will rise significantly in the future, it could be tempting to sell the shares and enjoy the resulting capital loss and then buy it back so you can enjoy the future capital gain. But the IRS does not permit you to take the loss if you buy the same (or similar) security back within 30 days of the sale. This is known as awash sale.

There are several ways to avoid the wash sale rule and still take advantage of the underlying strategy:

  • Wait more than 30 days to buy back the security
  • Buy a security with similar characteristics (e.g. sell shares of ABC growth mutual fund and buy shares of XYZ growth mutual fund)

The wash rule applies to transactions before and after the sell date. For example, you cannot buy additional shares of the security on October 1, sell the original shares on October 20 and then buy more shares of the same security on November 10. In essence, the wash sale rule covers a period of 61 days: the sell date plus 30 days before and 30 days after that date.

Tax Treatment of Variable Annuity Contracts
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