OUR E-MAIL INBOX INDICATESFor fund sales, see our story, "Calculating Taxes on Mutual Fund Sales You have two options when you figure your taxes; the trick is to make the decision before you sell the shares. Here's the lowdown.
Figuring 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.
Sounds easy enough, right? But now we start dealing with all the things that happen in the real world, such as dividend reinvestment programs (DRIP). Don't forget to include the cost of any shares purchased via a DRIP to your basis.
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. If not, you may have to do some research online or, depending on when the investment was purchased, visit the microfilm room at the local library.
Find the high and low prices for the acquisition date and average the two numbers. That's close enough for the IRS. If you don't know the exact purchase date, take your best shot. Despite what some people think, you are not required to have perfect information. Your obligation as a taxpayer is just to do the best you can with the data available now figuring taxes sometimes involves the use of estimates.
If you inherited the stock, your basis is the market value as of the original owner's date of death. Obviously, you won't get any official notification of this number, but you should at least know the date. Then it will take some more research to see at what price the stock traded on that fateful day.
Your basis is the same as the donor, unless you sell for a loss and the market value on the date of the gift was lower than the donor's basis. In that case, your basis is the market-value figure. Things get tricky when the company in question has been involved in merger, 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 a stock holding that you acquired at different prices, you have two alternatives for calculating your tax bill, which will be described briefly here. If you want more thorough instructions, see our story on mutual fund sales. (Note that the average-basis methods described in that story are not available to stock investors.)
The first method, called specific ID, 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. Sometimes, though, you need to make a trade-off based on the stock's holding period. Remember that sales of appreciated shares owned for one year or less are taxed at "ordinary income" rates. Stocks held for over a year are taxed at no more than the maximum long-term capital gains rate, which for most investors is lower than their income tax rates.
As a result, you are sometimes better off selling slightly cheaper shares that you've held longer. 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.)
But don't start counting your tax savings just yet. In order to take advantage of the specific ID method, you must at the time of the transaction tell your broker which shares you are selling by reference to the acquisition date and per-share price. In turn, your broker must respond with a written confirmation of your instructions. Or you must keep some kind of proof regarding your oral instructions.
In other words, if you failed to follow this procedure for a sale, you can't suddenly decide the following April to use the specific ID method when preparing your prior year s tax return. You are stuck with the alternative FIFO method. That method is generally unfavorable in a rising market, because you are treated as selling your earliest-acquired (read: cheapest) shares first. However, when prices are going down, FIFO generally gives you decent results (maybe just 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 disallowed if you buy shares in the same company within 30 days before or after the loss transaction. You don't lose the loss forever, though. It is just added to the basis of shares acquired during the forbidden period. Then, when you sell those shares, you will reap the benefit of the loss.
One way to avoid a wash sale is to purchase a similar, rather than identical, stock after a losing sale. Say you have a loss in The Gap but still want to own a retail clothing stock. Go ahead and take the loss, then buy shares of, for example, Abercrombie & Fitch Co..