Series 6
Taxation Issues - Calculating Gains and Losses
Cost Basis
A key concept to understa nd in computing gains and losses is cost ba sis, since the a mount of ca pita l ga ins to be ta xed is ca lcula ted by subtra cting the investor's cost from the sa lea sis of a n investment, sta rt with the origina l price (plus a ny tra nsa ction costs). Next, a dd the dolla r va lue of dividends tha t were reinvested. This would a pply to both stocks in a dividend-reinvestment progra m a nd mutua l funds where dividends a re a utoma tica lly reinvested. Reinvested ca pita l ga ins a re a lso a dded to the cost ba sis for mutua l 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:
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 va lue, but you believe will rise significa ntly in the future, it could be tempting to sell the shares a nd enjoy the resulting ca pita l loss a nd then buy it ba ck so you ca n enjoy the future ca pita l ga in. But the IRS does not permit you to ta ke the loss if you buy the sa me (or simila r) security ba ck within 30 da ys of the sa lea s a wa sh sa le
There are several ways to avoid the wash sale rule and still take advantage of the underlying strategy:
A key concept to underst
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 v
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)
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