One of the toughest calculations taxpayers have to make is figuring out how much they owe Uncle Sam for their investment income.
Taxpayers generally have two options when calculating taxes owed after selling stock holdings, but there’s more flexibility for those who take action before selling the shares. “It’s important to look strategically at what your long-term holdings are and what you’re planning on selling over the next few years,” says Greg Rosica, tax partner in the personal financial services office for Ernst & Young.
Here’s the lowdown.
Figuring out the tax basis of your shares
When you sell shares, the tax gain or loss is calculated by comparing your tax basis in the shares sold to the sales proceeds, net of brokerage commissions and transaction fees. That sounds easy enough, but in reality, the process can become complicated.
Say you didn’t keep track of your basis and have lost all of your transaction statements. What should you do? First, check to see if you can get the information from your broker. Since 2011, investment firms are required to report “cost basis” information for stock and mutual funds to the Internal Revenue Service if they have it, and to issue 1099s to investors. Some exchange-traded funds and dividend reinvestment plans have started reporting the information too.
If you inherited the stock, your basis is the market value as of the original owner’s date of death. That information might be in the estate documents. You can look it up if you know the date of death by using MarketWatch’s Historical Quotes feature on the BigCharts site. Things get tricky when the company in question has been involved in a merger, a spin-off or stock-split transactions.
Specific ID method vs. FIFO
When you sell all of your shares in a particular stock, your tax basis is the sum total of the cost of all your share acquisitions. But if you are only selling a portion of your shares, and you acquired some shares at different prices, you have two alternatives for calculating your tax bill.
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The specific ID method enables you to designate which shares you’d like to sell. This is good, because you can reduce your tax bill by selling your highest-cost shares first. Remember though that sales of appreciated shares owned for one year or less are taxed at “ordinary income” rates, while stocks held for over a year are taxed at the long-term capital gains rate, which for most investors is lower than their income-tax rate. As a result, you could be better off selling slightly cheaper shares that you’ve held longer. To take advantage of the specific ID method, you must tell your broker at the time of the transaction which shares you are selling, in reference to the acquisition date and per-share price.
On the other hand, when selling losers, you are generally better off unloading shares held for the shorter period. That way, you’ll generate short-term losses, which can be used to shelter short-term gains otherwise taxed at those high ordinary income rates. (After you offset all of your capital gains, you can use the remaining losses to offset as much as $3,000 in ordinary income.)
The first-in, first-out method, which uses the basis of the shares purchased first, is generally unfavorable in a rising market, because it’s as though you’re selling your earliest-acquired (read: cheapest) shares first. However, when prices are going down, FIFO generally gives you decent results (possibly as good as the specific ID method.)
As with mutual-fund shares, you have to watch out for the “wash sale rule” whenever selling regular stock for a tax loss. Under this little trap for the unwary, your anticipated loss is prohibited if you buy shares in the same company within 30 days before or after the loss transaction. In essence, the IRS treats that as though you kept holding the same security, says Rosica. One way to avoid a wash sale is to purchase a similar, rather than identical, stock after a losing sale.
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