What Is a Disposition?
A disposition is the act of selling or otherwise "disposing" of an asset or security. The most common form of a disposition would be selling a stock investment on the open market, such as a stock exchange.
Other types of dispositions include donations to charities or trusts, the sale of real estate, either land or a building, or any other financial asset. Still, other forms of dispositions involve transfers and assignments. The bottom line is that the investor has given up possession of an asset.
- A disposition refers generally to the selling securities or assets on the open market.
- Dispositions can also take the form of transfers or donations to charities, endowments, or trusts.
- For business dispositions, the SEC requires certain reporting to be completed depending on the nature of the disposition.
- Dispositions that are donations, assignments, or transfers, can often be used to take advantage of beneficial tax treatment.
Understanding a Disposition
A "disposition of shares" is perhaps the most commonly used phrase regarding a disposition. Let’s say an investor has been a long-time shareholder of a particular company, but lately, the company may not be doing so well.
If they decide to exit the investment, it would amount to a disposition of that investment—a disposition of shares. Most likely, they would sell their shares through a broker on a stock exchange. Ultimately, they have decided to get rid of, or dispose of, that investment.
If the sale results in any sort of capital gain, then the investor will have to pay capital gains tax on the profits of the sale if they meet the requirements set by the Internal Revenue Service (IRS).
Other types of dispositions include transfers and assignments, where someone legally assigns or transfers particular assets to their family, a charity, or another type of organization. Mostly this is done for tax and accounting purposes, where the transfer or assignment relieves the disposer of tax or other liabilities.
For example, if an investor purchased stock for $5,000 and the investment grew to $15,000, the investor can avoid the capital gains tax on their profit by donating it to a charity. The investor is then able to include the entire $15,000 as a tax deduction.
The Securities and Exchange Commission (SEC) has very specific guidelines on how these dispositions must be reported and handled. If the disposition is not reported in the financial statements of a company, then pro forma financial statements are required if the disposition meets the requirements of a significance test.
"Significance" is determined by either an income test or an investment test. An investment test measures the investment value in the unit being disposed of compared to total assets. If the amount is more than 10% as of the most recent fiscal year-end, then it is considered significant.
The income test measures if the "equity in the income from continuing operations before taxes, extraordinary items, and cumulative effects of changes in accounting principles" is 10% or more of such income of the most recent fiscal year-end. In certain situations, the threshold level can be increased to 20%.
The Disposition Effect
Behavioral economics also has something to say about one's propensity to sell a winning vs. losing position based on the concept of loss aversion. The "disposition effect" is a term that describes investor behavior in which they have a tendency to sell winning investments too early before realizing all potential gains while holding on to losing investments for longer than they should, hoping that the investments will turn around and generate a profit.
This effect was first introduced by Hersh Shefrin and Meir Statman in 1985 in their paper, "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence." Studies show that investors should do the exact opposite of what the disposition effect states they tend to do.