At this point, the sensible investor may pause amid the complexity and wonder, "How do I know if I'm getting rich?" The answer lies in a comparison of what he paid for his investments and what their current market value is, but this is actually harder to determine than you might think. It is not always easy to figure out exactly how much you spent on a particular security.
Let's say you bought 800 shares of Descartes Corporation common shares at $10 six months ago. The price shot up quickly, and it looked like there was no end in sight. Three months later you bought another 200 shares at $18. But this past month, as the share price stalled out at $20, you figured the rocket ride was over and Descartes stock had a lot more downside potential than upside, so you sold 500 of your 1,000 shares and kept the rest because you still believe that Descartes has strong long-term potential.
How much did you make?
Well, you clearly sold your holdings for $10,000 ($20 x 500 shares), but how much of a gain did you realize?
A share is a commodity. That is, one share is completely indistinguishable from any other share of the same issue. So did you sell 500 of the first 800 shares, or did you sell the 200 shares you bought most recently plus 300 of the first 800?
Your gain or loss will depend on the accounting treatment you choose to apply to selling a partial position. The first scenario would be an example of the treatment called First In, First Out or, FIFO. The second is called Last In, First Out, or LIFO.
- Under FIFO, you sold the first shares you bought, the ones at $10, so your cost for these shares was $5,000 ($10 x 500 shares). Subtract that from your $10,000 selling price, and you made $5,000.
- Under LIFO, you sold the last shares you bought, the ones at $18. But wait, you only have 200 of those. Your cost for those 200 shares is $3,600 ($18 x 200 shares). Your cost for the other 300 you sold is $3,000 ($10 x 300 shares). Combined, then, your LIFO-calculated investment is $6,600 ($3,600 + $3,000). Subtract that from your $10,000 selling price, and you made $3,400.
In this example, this simple difference in inventory accounting caused a difference of $1,600; the FIFO calculation, in other words, was almost half the LIFO calculation. If you did this enough times throughout the year, it would make a significant difference in how much taxable revenue from capital gains your client would have to report. As you can see, LIFO accounting is better for the client - for tax purposes, if not for bragging rights - in a rising market.
Specific Shares Method
Another option, one that usually requires much more bookkeeping, is identifying specific shares by the date when the shares were purchased at the time the order is entered to sell the shares. This is done when the stockholder is trying to manage his or her taxable income, A n investor who is trying to reduce his or her taxable income may wish to sell securities at a loss and may identify the shares being sold as the shares purchased at a price over the current market value. .
Securities given as gift are to be valued by the donor at the market value on the day of the transfer. To the recipient this could well be taxable income, and she should value it as if she purchased it for $0. Shares that are inherited are valued at the fair market value on the date of death. Any gain will be based off of the market value of the securities on the date of death and not on the original purchaser's cost base.
Shares from Conversion
InvestingMutual funds aren't guaranteed profit-makers, but with the right calculations and timing, you can avoid major losses.
TaxesThe method of identifying cost basis can help you to get the most out of reduced tax rates.
InvestingWe explain why Last-In-First-Out is banned under IFRS
InvestingBy using LIFO (last in, first out) when prices are rising, companies reduce their taxes and also better match revenues to their latest costs.
TaxesWhat financial advisors (and their clients) need to know about capital gains taxes in 2015.
TaxesKeep more of your money in your pocket with these seven guidelines.
Financial AdvisorInvestors who know the rules can turn their losing picks into tax savings. Here's how to deduct your stock losses.
InvestingInvesting with options can be a great strategy, but you need to do your research first or the risks can outweigh the benefits.
TradingLearn how this simple options contract can work for you, even when your stock isn't.
TaxesFind out how taxes are applied to your investment returns and how you can reduce your tax burden.