Three Tax Questions Answered
We are in the final quarter of the year, now, and people are starting to think about taxes and how to avoid them.
By Ann Coleman (TMF AnnC)
November 13, 2000
I'm not a tax expert, but I do get a fair number of questions about taxes. Sometimes I even know the answers. Following up on Friday's column about Tax-Loss Selling, here are my stock answers to the three questions I've been asked most frequently about taxes and investing. For everything else, we have Roy Lewis (TMF Taxes) and Phil Marti (TMF ExRO). They hang out in the Tax Strategies area and provide the definitive answer for just about anything you've ever wanted to know about taxes, but were afraid someone would spend three hours explaining it, so you never asked.
Question 1: This first one is my favorite. People write in whispering (not easy in email), as though they had just figured out a secret way to beat the system. Bless their avaricious little hearts. It goes something like this: I bought a stock for $50 a share, and it split; then I sold half of it for $35 a share. Since�I bought 100 shares at $50 and sold 100 shares at $35, I have a $15 per share loss, right?
Sorry, guys, Uncle Sam ain't that dumb.
If you bought 100 shares at $50 a share, and the stock split 2-for-1, the price you paid was automatically cut to $25 per share (and the number of shares you own doubled, so the total value is exactly the same). So, now you're starting from a $25-per-share cost basis (not counting commissions). Then the stock price went up to $35, where you sold half of your shares. You don't have a tax loss. You made money. (And you know it!)
The stock price is irrelevant. There isn't even any place on Schedule D to put the stock price. What the IRS looks at is what you paid for the entire block of stock and what you sold it for. If you didn't sell the entire block, you must adjust your "cost basis" to reflect what you actually paid for the shares of stock you sold. In the example above, you paid $25 per share for the 100 shares sold, or $2,500. You sold it for $3,500.
Cost basis is the key concept. It allows for no slack. Never mind splits, spin-offs, acquisitions, or anything else that happened to the stock along the way. Calculation of cost basis is supposed to include all that. That's why the IRS uses the special term "cost basis" instead of something like "purchase price."
Here's how you calculate the cost basis for the example above. First, let's pretend that you sold the entire lot:
-- Bought 100 shares at $50 per share, plus $10 in commission = Cost basis is $5,010
-- Stock split 2-for-1, so you have 200 shares at $25 per share, your commission on the original purchase was still $10 = Cost basis is still $5,010
-- Sold 200 shares at $35 per share, minus $10 in commission = Selling price is $6,990
-- Selling price minus cost basis = �$1,980. That's your capital gain
Now, if you sold 100 shares, you sold half of the stock that you originally purchased for $5,010 so your cost basis for the stock you sold is half of $5,010, or $2,505. (After the split, your adjusted purchase price was $25 per share, so 100 shares would be $2,500 and then half of the $10 commission is $5, making your cost basis $2,505.)
The stock could have split 10 times and it wouldn't make the slightest bit of difference because the IRS never even asks about the number of shares. All it wants to know is what you paid for the asset you are selling.
-- $5010 / 2 = Cost basis for stock that was sold is $2,505
-- Sold 100 shares at $35 minus $10 in commission = Selling price is $3,490
-- Selling price minus cost basis = $985 (see, you made money)
Question 2: Can I sell the Foolish Four stocks I'm not renewing early if they are showing a loss?
Well, yeah. The rule about holding your Foolish Four stocks for a year and a day is there to ensure that your gains are taxed at the lower long-term capital gains rate. It doesn't apply to losses or to any Foolish Four transactions that are in IRAs.
From a tax standpoint, a short-term loss is better. Depending on your other transactions for the year, it might or might not make any difference, but when it does matter, a short-term loss has more "buying power" than a long-term loss.
Whether your losses are short- or long-term won't matter if all your gains are long-term or if they are all short-term. It's only when you have both that you need to worry about timing your losses. Ideally, you wouldn't have any losses. But investing is never ideal, so if you've got 'em, use 'em.
When you have both long- and short-term gains, long-term losses will be used to offset the long-term gains first, but those long-term gains are taxed at a lower rate than your short-term gains. So, you would prefer to offset the higher-tax, short-term gains first, whenever possible. If you can do that by selling a loser a few days early, great.
Don't worry about having "too many" short-term losses. If you have more short-term losses than needed to wipe out your short-term gains, they will first be used to offset your long-term losses, then your regular income. OK, maybe you should worry about having too many short-term losses. That's never good. But tax-wise, it's not a problem.
Question 3: This one really hasn't been asked all that frequently, but it should be, so I'm including it here: What's this I hear about an 18% capital gains rate?
That's the new super-long-term capital gains rate, which goes into effect next year. It's even better for those in the 15% tax bracket. Those guys will only pay 8% (instead of 10%) on stock that they have held for more than five years, if they sell it on or after January 2, 2001. That's a nice incentive to hold those long-term stocks for a few more months, as if the market these days isn't incentive enough.
Taxpayers in the 28% and above brackets will also see their long-term capital gains rates drop two percentage points, from 20% to 18%, starting next year. However, the rate will only apply to stock purchased after January 1, 2001. Except -- there's always an exception, so check out Roy Lewis's article on the New Super Foolish Tax Rates for all the gory details on how to take advantage of the new rate, even for stocks that you might already own.
Fool on and prosper!
