Taxation of Investments

Cost basis and identifying shares

Cost basis is the purchase price plus commissions and other acquisition costs. Gain or loss on a sale is the net proceeds minus basis.

Basis is adjusted by events. A stock dividend or split spreads the same basis across more shares, so basis per share falls. A return of capital distribution reduces basis rather than being immediately taxed, and once basis reaches zero further returns of capital are taxed as capital gain. Reinvested dividends create new shares with their own basis, which is the single most common cause of customers overpaying tax on a long-held fund. Accretion of original issue discount raises basis; amortization of premium reduces it.

When a customer has bought the same security at different prices and sells part of the position, the shares sold must be identified. The default is first in, first out — the earliest shares are treated as sold, which in a long-appreciated position produces the largest gain. Specific identification lets the customer designate which shares are sold, provided the designation is made at or before the sale and confirmed in writing. Average cost is available for mutual fund shares.

Specific identification is the customer's most useful tax tool and it is time-sensitive: the choice must be made at the sale, not at tax time. A representative who does not raise it before executing has cost the customer the option.

Holding periods and netting

A holding period longer than one year produces long-term treatment; one year or less is short-term. The period begins the day after acquisition and ends on the date of sale.

Long-term capital gains are taxed at preferential rates; short-term gains are taxed as ordinary income. That difference is the reason holding periods are worth tracking at all.

Gains and losses are netted in a defined order: short-term gains against short-term losses, long-term gains against long-term losses, and then the two net figures against each other.

A net capital loss may be deducted against ordinary income up to $3,000 per year, with the remainder carried forward indefinitely. Losses carry forward with their character preserved.

Holding periods tack in several situations covered earlier: stock received in a split or stock dividend takes the original shares' holding period; shares acquired on conversion of a convertible security take the convertible's holding period; and shares received as a gift generally take the donor's holding period.

Worked example. A customer has a $9,000 short-term loss, a $2,000 short-term gain and a $4,000 long-term gain. Netting short-term gives a $7,000 short-term loss; netting that against the $4,000 long-term gain leaves a $3,000 net loss, all of which is deductible this year with nothing carried forward.

The wash sale rule

Internal Revenue Code section 1091 disallows a loss on the sale of stock or securities where, within 30 days before or after the sale, the taxpayer has acquired substantially identical stock or securities.

The window is 61 days in total: 30 days before, the day of sale, and 30 days after. Candidates who read it as 30 days after only are answering half the rule.

Substantially identical includes the same security, and it includes options and convertible securities on the same underlying — buying a call on the same stock within the window triggers the rule. It does not include a different issuer's stock in the same industry, and generally does not include a bond of the same issuer with a materially different coupon or maturity.

The disallowed loss is not lost forever. It is added to the basis of the replacement shares, so the deduction is deferred until the replacement position is finally sold. The replacement shares also inherit the original holding period.

The rule disallows losses only. A gain realized inside the window is fully taxable, so a customer cannot use the wash sale rule to defer a gain.

The practical selling point: a customer harvesting a tax loss in December must either stay out of the security for 31 days or buy something that is not substantially identical — a different issuer, or a broad fund rather than the individual stock.

Dividends and interest

Qualified dividends are taxed at long-term capital gains rates. To qualify, the dividend must be paid by a US corporation or a qualified foreign corporation and the shareholder must have held the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Preferred stock has a longer holding requirement for dividends attributable to periods over 366 days.

Non-qualified dividends are taxed as ordinary income. Distributions from REITs are generally ordinary income, as lesson 5.3 covered, because the REIT paid no corporate tax on them.

Interest is ordinary income, with the exceptions already established: municipal interest is generally exempt federally, Treasury interest is exempt from state and local tax, and both were covered in Modules 3 and 4.

A capital gain distribution from a mutual fund is long-term to the shareholder regardless of their own holding period.

Accrued interest paid on a bond purchase is not part of the buyer's basis; it is recovered by reducing the taxable interest reported when the next coupon arrives.

Margin interest is deductible as investment interest expense against net investment income, subject to limitation — and note that interest incurred to carry tax-exempt securities is not deductible at all, which is another reason a customer should not borrow to buy municipals.

Gifts and inheritances

These two have opposite rules and the exam relies on candidates confusing them.

A gift of securities generally carries over the donor's cost basis and the donor's holding period. If the donor bought at $10 and gifts when the stock is $40, the recipient's basis is $10 and a later sale at $50 produces a $40 gain. The exception applies where the fair market value at the gift is below the donor's basis: for computing a loss, the recipient uses the lower fair market value, which prevents a built-in loss being transferred.

An inheritance receives a stepped-up basis: the recipient's basis is the fair market value at the date of death, or an alternate valuation date if elected. All appreciation during the decedent's life escapes income tax entirely. And the holding period of inherited securities is automatically long-term, regardless of how long anyone held them.

The difference produces the standard advice question. A customer with a highly appreciated position who wants to benefit a family member: gifting transfers the embedded gain, bequeathing eliminates it. If the objective is to minimize the family's total income tax, holding until death is more efficient — though estate tax and the customer's own needs obviously enter the picture.

Gift and estate taxes are unified under a single lifetime exclusion, so lifetime gifts above the annual exclusion consume the exclusion available at death. IRC section 2503 provides the annual exclusion, indexed for inflation, which allows a donor to give that amount per recipient per year without using any of the lifetime exclusion and without filing a gift tax return. Gifts between spouses who are US citizens are generally unlimited.

A 529 plan contribution is a completed gift for these purposes, with the five-year election mentioned in lesson 9.4 allowing five annual exclusions to be used at once.