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Articles: Get up to speed on cost basis rules

It is not how much you make, but actually how much you keep after-tax that truly counts in the real world. That is why it is especially important to understand the "cost basis" rules affecting investments. It is now easier for investors to arrive at basis than it was in the not-so-distant past, but thorny issues may still present themselves.

Starting point:  When you sell or otherwise dispose of securities, you generally realize a gain or loss on the difference between the sales prices and the basis.  For this purpose, the basis is usually the acquisition cost plus certain adjustments such as broker commissions. Also, basis must be adjusted for events like stock splits and mergers.

A capital gain or loss is short-term for securities held a year or less and long-term if held longer than a year.  Gains and losses are netted at the end of the year. For 2014, the maximum tax rate on net long-term capital gain is 15%, but it is increased to 20% for those in the top ordinary income tax bracket.

The tax computations for a securities sale can be a snap, relatively speaking, if you sell all the shares of a particular security you own.  But complications may arise if you hold multiple shares and only sell some of them. In addition, you may not have the records showing the initial cost of the securities. Due to a recent law change, financial institutions are required to submit information returns including the basis of securities sold, plus the amount of the sales proceeds, as well as indicating if a gain or loss is short-term or long-term. These rules were phased in for different financial products.

They apply to:

  • Stock shares acquired after 2010;
  • Mutual fund shares and stock in a dividend reinvestment plan acquired after 2011; and
  • Other securities such as notes, bonds, commodity contracts and options acquired after 2013.  (Note that this rule initially applied to securities acquired after 2012 but was postponed for one year.)

Thus, a lot of the hassle pertaining to the tax treatment for securities sales is removed.  You do not have to hunt down records to show the basis of the investments. Nevertheless, for dispositions  of  assets  acquired  prior  to  the  effective dates already mentioned for instance, stocks you bought before 2011 good record-keeping on your part is still essential.

Finally, note that you may face complications when you sell shares of a particular security and retain some shares of the same security.  The IRS will generally assume that the first shares acquired are the first ones sold (the First-In, First-Out [FIFO] method). But you may improve your tax situation by specifically identifying shares instead of relying on the FIFO method.  Obtain expert advice with respect to the tax consequences of your transactions.

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