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Tax Center
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Learn about the tax implications associated with investing. Know the rules set by Uncle Sam, and create tax advantaged investment strategies that work in your favor.
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Introduction
As many U.S. residents are aware, April 15 is one of the most important days of the year. And no, it is not a national holiday. April 15th is also known as "Tax Day" which is the deadline to file individual tax returns. We pay taxes on the income we earn, and money made from investments is
no exception. By understanding the relationship between taxes and your
portfolio, you can create an investment strategy that actually
increases your after-tax income. Preparing taxes can be a tedious and time-consuming task and one of the main reasons why we seek help from an accountant or a tax advisor. Please keep in mind that record
keeping is critical for all types of tax document preparation, and is
certainly the case when you make securities transactions. This section will help provide some clarification on basic tax definition and terms. If you have any additional questions, please consult your accountant or your tax advisor for assistance.
Terminology [Back to top]
Before we get started, let's cover some basic terminologies related to taxes and investing:
Schedule D |
This is the tax form investors use to report their capital gains and losses. If you sold any of your securities during the calendar year, the IRS will require for you to report the transactions.
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Dividends |
Payments from a stock or mutual fund company issued to shareholders. Depending on your tax bracket, the tax rate ranges from 5% to 15%.
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Interest Income |
Income received from interest bearing securities such as treasuries, corporate bonds, savings bonds, CDs, bank accounts, credit union accounts and so forth.
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1099 |
This form is provided to investors who have accrued more than $10.00 in interest or made sell transaction(s) during the tax year. It is provided to investors who have a valid social security number and used to report other sources of income to the IRS. These are made available to investors by the end of January. Information on this form include ordinary (qualified) dividends, non-qualified dividends, interest, capital gain distributions, foreign tax withheld and sell side transactions.
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1099-R |
This form is provided only if you made a distribution (withdrawal) from your IRA during the tax year. Distributions include excess contribution, premature distributions, Required Minimum Distribution (RMD) and Roth Conversions. This form is made available by the end of January.
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1042-S |
This form is furnished to all international account holders. They are mailed to customers in April.
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Trade Confirmations |
When an order to purchase or sell a security is executed, a written statement is provided to the customer with the transaction details. Investors are encouraged to maintain good records of their transactions so that they can properly calculate their taxes.
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Trade Settlement |
Date when the security must be delivered (sell side) and when the cash payment must be issued (buy side). For most securities, the trade settlement date is T+3, or three business days after the original transaction. Options and select mutual funds have a one business day settlement period.
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Realized and Unrealized Gain/Loss |
Any security that will incur a gain or loss when the security position is closed is referred to as unrealized gains/losses. Any gain/loss that has already occurred when the security position was closed is a realized gain/loss. For tax considerations, we focus on realized gains/losses.
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Ordinary (Qualified) Dividends |
Per the Jobs and Growth Tax Relief Reconciliation Act of 2003 (effective since May 2003), these types of dividends are eligible to be taxed at a reduced rate (lower than the income tax rate). These dividends are paid by American companies or by qualified foreign companies. A holding period requirement must also be met in order for a dividend to be classified as qualified. (The dividend tax rate is 15% or less for most investors).
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Non-Qualified Dividends |
Dividends not eligible for the reduced rate. These are taxed at your income tax rate. (Any dividends issued for mutual fund shares held less than 61 days will be classified as non-qualified). Taxable interest income, capital gains distributions also fall into this category.
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Calculating Capital Gains & Losses [Back to top]
As a U.S. investor, the IRS levies taxes only on realized gains. Furthermore, realized capital gains can be offset by realized capital losses. If realized capital losses exceed realized capital gains, that amount can even be used toward the reduction of ordinary income, up to $3,000 per year. This adds many dimensions to think about to make efficient investment decisions.
The key to remember is that unrealized gains and losses will carry over into the next year if no action is taken, and if the prices of the securities are not expected to rise or fall significantly in the near future, you can figure out which gains/losses should be realized to reduce your tax liability.
The cost basis is the cost of the original shares along with adjustments such as commission paid. If there is a profit made from a transaction, it is classified as a capital gain. If there is a loss made from a transaction, it is classified as a capital loss. Let's take an example to illustrate capital gains, capital losses and cost basis.
Assume John Doe purchased 10 shares of XYZ at $20.00/share and the commission paid was $10.00. The cost basis for the buy transaction will be 10 x $20.00/share = $200.00 + $10.00 (commission paid) = $210.00 cost basis.
There are two possible scenarios:
- John Doe decides to sell 10 shares of XYZ at $25.00 per share (commission = $10.00). John can calculate his transaction as follows: 10 x $25.00/share = $250.00 - $10.00 (commission) = $240.00.
In this case, John had a capital gain from this transaction because: $240.00 (sell transaction) - $210.00 (cost basis) = +$30.00.
- John Doe decides to sell the 10 shares of XYZ at $10.00 per share (commission = $10.00). The transaction can be calculated as follows: 10 x $10.00/share = $100.00 - $10.00 (commission) = $90.00.
In this case, John had a capital loss from this transaction because: $90.00 (sell transaction) - $210.00 (cost basis) = -$120.00.
Holding Period [Back to top]
Depending on how long securities have been held, capital gains can be taxed at a lower rate than that of your ordinary income. If you hold securities for more than one year, any gains from the sale of these securities are called Long-term capital gains, and are taxed at 15% as opposed to the ordinary income rate of up to 35%.
To minimize the impact of taxes on your investments, monitoring the holding period is very important. For example, if you are considering selling securities that you bought 11 months ago, holding it for an additional month will qualify the gains as long-term. Unless the market price of securities falls substantially in the final month, you will benefit from the lower tax rate on the gains. By the same token, if an investor wishes to benefit from the lowered tax rate then he or she should try to avoid Long-term capital losses, which would offset the Long-term capital gains which are taxed at a favorable rate.
Suppose your tax rate is 30%, and you have $3,000 of realized short-term capital gains and $3,000 of realized long-term capital gains. Now assume that you have securities that will generate loss of $2,000 when sold.
If the stock is sold as a short-term loss, $2,000 of your short-term gains will be offset. The remaining $1,000 will be taxable at 30%, resulting in $300 (short-term) + $450 (long-term) = $750 tax due. |
If you sell the stock as a long-term loss, $2,000 of your long-term gains will be offset. The remaining $1,000 will be taxable at 15 % , resulting in $150 (long-term) + $900 (short term) = $1050 tax due. |
Short-term gains are taxed at a higher rate, so short-term losses will effectively reduce the taxable amount. Long-term gains are taxed at a lower rate, so although long-term losses will reduce the taxable amount, the effect is not as significant as for short-term. |
If you received a dividend in the form of stock and you intend to sell it, the same rule s apply. Just be aware that the holding period begins on different dates, depending on whether the dividend is taxable or not. For a taxable stock dividend, the holding period starts the day after the distribution date. But the holding period of a tax-free stock dividend starts the day you purchased the original stock.
Note:
*December 31 st is the last day you can execute a sell order for the current year's tax purposes, even though the transaction will not settle until the following year.
**Short sell transactions are an exception to this rule. Their settlement date must fall on or before December 31 st to be considered for the current tax year. The realized gain/loss is calculated based on the settlement date, and not the date of the original transaction.**
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Tax Lots [Back to top]
A "lot" is defined as the shares in a single transaction. Assume you made 3 separate purchases of 100 shares of IBM at different prices in the past year, your portfolio will display a position of 300 shares, and each purchase is considered a different "lot" of 100 shares. When selling securities, by knowing which lot you are selling, you can control the amount of realized gains and losses and use it to your advantage! (Without specifically identifying lots with your broker at the time of the transaction or shortly after the execution, the IRS will use FIFO (First In, First Out), which automatically pairs sales of securities with the first lots that were bought.)
Here's an example: You purchased 100 shares of FZ Steel Co. at $5/share in January. Three months later you purchased another 100 shares of FZ Steel Co. at $7/share. The stock is now trading at $10/share.
Purchase 1: $5 x 100 = $500 |
Purchase 2: $7 x 100 = $700 |
Total price paid = $1,200 |
$10 x 200 = 2,000 |
Today the stock is worth = $2,000 |
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Net unrealized gain is $800 |
If you decide to sell 150 shares of FZ Steel Co. when the price reached $10/share, how do you determine what price you paid? The 150 shares you are selling can include any combination of shares from your first purchase or the subsequent purchase. Let's calculate how much you paid for the 150 shares:
If you take 100 shares from the $5 lot, and 50 shares from the $7 lot (FIFO):
(100 shares X $5) + (50 shares X $7) = $500 + $350 = $850 Cost Basis
(150 shares X $10) - $850 = $1,500 - $850 = $650 Total Unrealized Gains
Using the FIFO method, you have a realized gain of $650 (excluding commissions and fees).
Now let's try another method , and take 75 shares from each purchase:
(75 shares X $5) + (75 shares X $7) = $375 + $525 = $900
(150 shares X $10) - $900 = $1,500 - $900 = $600
By choosing shares from specific lots, you have a realized gain of $600 (excluding commissions and fees). This method results in $50 less in taxable capital gains when compared to the FIFO method.
Note: Keep in mind that matching the lot does not affect the total unrealized gains of all your positions, just the amount of taxes you have to pay. |
Each transaction will have unique properties and very different methods for matching lots. With good record keeping and some simple math, careful lot-matching can become a successful part of your investing strategy.
Don't Abuse the System: Wash Sales [Back to top]
The Wash-Sale rule was created by the IRS to disallow the loss deduction from the sale of securities if repurchased by a seller or spouse within the Wash-Sale period. The Wash-Sale period is defined as 30 days before and 30 days after the sale date, totaling 61 days (including the sale date).
When you have a Wash-Sale:
- you are not allowed to claim the loss deduction
- an adjustment must be made by adding the loss to the cost basis of security repurchased
- the holding period of repurchased securities includes that of securities you sold
For example, you have 500 loss-generating shares of Fiko Steel, Co. that you bought at $40/share and you want to sell at $25/share to take a loss for the deduction. About 15 days after the sale, you hear some good news about Fiko Steel, Co. and buy back 500 shares at $30. Even though you experienced a loss of $15 per share, you are not allowed to claim the loss since it was repurchased within the Wash-Sale period. In addition, since you have a Wash-Sale, you have to adjust the cost basis of the new purchase by adding $15/share, resulting in a cost basis of $45/share.
The Wash-Sale rule applies only if you purchase "substantially identical" securities. Here are some examples of securities that are not considered substantially identical:
Bonds issued by one institution, but with different maturity dates and different interest rates
Common stock and preferred stock of the same company
Stocks of different companies even if they are in the same industry
Short Sales [Back to top]
The general rule in reporting taxes from a short sale is that you do not pay taxes until the position is closed. A loss on a short sale is not deductible until the replacing shares are delivered to the broker. Gains and losses on a short sale are reported in the year in which the short position is closed. For the most part, the realized gain/loss from a short sale is treated as a short-term capital gain/loss, regardless of the holding period , since the "time period" which you owned the actual stock is usually less than a day. There are special situations regarding taxes and short sales that go beyond the scope of this tutorial, so please consult your tax advisor for more information.
Special Tax Situations [Back to top]
Cash In Lieu: Fractional shares are rarely credited directly to the brokerage account in the case of mergers (company issues new shares at a determined rate), or stock splits. If the transaction involves any fractional shares, the stock company will most likely issue a one-time cash compensation. For tax purposes, you will be required to factor in the fractional shares in to your original cost basis. Subsequently, the fractional share sell transaction must be reported on your annual returns. (Please check with the stock company because the situation varies from firm to firm. Some companies may elect to issue cash in lieu while others may not).
Stock Dividend: Some companies may issue additional shares of stock to their shareholders. In this event, the new shares must be factored in to the original cost basis. The holding period for these newly issued shares will be calculated from the original purchase date of the stock. (You are not required to report taxes when you receive the stock dividend. However, once you sell the shares you must report the transaction.)
Cash Dividend: These must be reported on your Schedule D. They can be classified as qualified or non-qualified, depending on the stock company and the length of time the security was held.
Cash Payment Through Mergers: (ABC company announced a merger with XYZ at a rate of 0.5 new shares for each share of ABC in addition to a cash payment of $1.00 per share of ABC). The merger details must be first obtained, indicating the amount of shares issued and the rate of the cash payment. You will most likely be notified of the details beforehand. If not, please visit the company's website or contact their Investor Relations Department for assistance. Based on the information provided, please determine the merger consideration along with the original cost basis. Depending on the situation, the procedure can be quite complicated. We advise that you contact your tax professional for assistance if you have any questions.
Stock Splits: Please keep in mind that in the event of a stock split, the value of your holding will remain the same. Therefore, kindly adjust your cost basis based on the ratio. For an example, let us assume you originally purchase 10 shares of ABC at $5.00 per share (total cost = $50.00, assume no commissions were charged for simplification).
ABC recent announced a stock split for 2:1. This means that for every one old share, the stock company exchanges it for two new shares. Therefore, you will now own 20 shares at $2.50 per share (total cost = $50.00)
Dividend Reinvestment: Some investors choose to allocate cash dividend payments towards the purchase of additional shares of security. If you received any dividends during the tax year, you must report the amount in cash on the Schedule D. Please keep accurate records of the cost basis. When you sell the reinvested shares, you are to report any profits on your returns.
Mutual Fund Capital Gains Distributions: These are taxed as ordinary income.
Money Market Mutual Funds: The price per share is normally maintained at a constant rate of $1.00 per share, and no gain/loss will be calculated when you sell. However, the fund will issue the payments in the form of dividends.
Worthless Securities: A worthless security is a stock that is no longer publicly traded or has since declared bankruptcy (i.e. Enron, old K-Mart to name a few). You may notice that trading volume has ceased for a significant period of time and the trade symbol has since been replaced by a series of numbers and letters. Investors take a risk when they purchase stock securities. Since we cannot predict the future, there are a select few companies that eventually dissolve leaving investors with a loss. Investors can remove these worthless securities from their accounts and essentially declare a capital loss on that position. Worthless positions can be removed from the brokerage account by giving us a call or simply by sending us an e-mail. The "penny for lot" transaction will appear on your account statement.
*This information should not be construed as providing tax or legal advice. Please consult with your tax advisor or attorney regarding your individual situation.
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