The law divides investment profits into different classes determined by the calendar. There are "long-term" gains and "short-term" gains. Short-term gains come from the sale of property owned one year or less; long-term gains come from the sale of property held more than one year.
What's the difference? The tax rate you pay depends a great deal on the calendar, and it's more important than ever thanks to the cuts in the capital gains tax rate.
When figuring the holding period, the day you buy property does not count but the day you sell it does. So, if you bought a stock on April 16, 2005, your holding period began on April 17. Thus, April 16, 2006, would mark the end of the first year. If you sold on that day, you would have a short-term gain or loss. A sale on April 17 would produce long-term results, though, since you would have held the asset for more than one year.
There's one more exception. To encourage investment in small business, the lawmakers created a 50% exclusion for the gain from the sale of a special kind of stock. After Congress established this special 50% exclusion, they decided to tax the remaining amount at a special rate of 28%. The net result is that the gain on your sale of special 5-year stock is taxed at 14%.
This break applies only to "qualified small-business stock" that you buy at its original issue (after August 10, 1993) and own for at least five years before selling. To target small businesses, the break applies only if the company has gross assets under $50 million when the stock is issued and the stock of certain kinds of companies can't qualify at all, including financial, farming, professional service and health-related firms.
And, you don't have to own the same small company stock for the full five years to qualify for this tax break. You may sell stock after you've held it for more than six months and keep the tax break alive if, within 60 days, you buy stock in another qualifying small company. In other words, you can roll over your investment from one qualifying small company to another. As long as you own the new stock for at least five years (including the time you owned the previous shares), you can qualify to claim half of the profit tax-free.
There's also a limit on how much gain any taxpayer is allowed to exclude under this provision. The exclusion is limited ten times your basis in the stock or, if more, $10 million from the stock of a single issuer. And, if you are subject to the alternative minimum tax, part of the gain you exclude under this provision is subject to the AMT. You include 7% (prior to 2003 it was 42%) of the tax-free profit in income for AMT purposes.
If you're still interested, be aware that you may have a tough time finding qualifying stock. Remember, it can't be traded on the exchanges because to qualify, you must buy the stock at its original issue. Investments that qualify will generally be speculative, high-risk deals and your broker may not even handle them. Remember, it never makes sense to make an investment primarily to get a tax break.
Here's another way Congress uses the tax rules to encourage investment in small businesses: the law allows you to defer the tax due on gains from the sale of any publicly traded securities if, within 60 days of the sale, you roll over the proceeds of the sale into a specialized small business investment company. A SSBIC is a company or partnership licensed by the Small Business Administration that steers investors' money into minority-owned businesses.
This provision lets you put off the tax on the gain from the sale of securities, not avoid it completely. Your basis in the SSBIC stock is reduced by the amount of gain rolled over, so when you ultimately sell the SSBIC stock, your profit will include the gain from the previous sale.
In addition to having to complete the rollover within 60 days, the amount of gain you can defer is limited to $50,000 in any year and $500,000 over your lifetime. If you're interested in SSBIC stock, contact the Small Business Administration for a list of qualifying companies.
Although capital gains usually are fully taxable, there is a restriction on your right to deduct capital losses you suffer. Losses can be used to offset any amount of capital gains, but no more than $3,000 of excess loss can be deducted from other income, such as your salary or interest. Any net loss in excess of $3,000 can be carried over to future years to be deducted against capital gains or up to $3,000 of other income each year. The staggering losses on Wall Street after the tech wreck that ushered in the new century prompted many members of Congress to call for increasing the $3,000 loss limit. (There's been a lot of inflation since that $3,000 cap was set in 1978.) So far, the lawmakers haven't made the change.
It is important to note that the tax basis of property owned by a taxpayer at the time of death is "stepped-up" to its date-of-death value. Since the basis is the amount from which any gain or loss will be figured when the new owner ultimately sells the property, this means that the tax on any appreciation that occurred during the taxpayer's life is forgiven. The person who inherits the property—a house, say, or stocks and bonds—would owe tax only on appreciation after the time of death. This break also comes into play for a widow or widower who owned property jointly with his or her spouse. You automatically get long-term gain treatment on the sale of inherited property, even if you have owned it for less than 12 months when you sell. (As part of the drive to permanently repeal the estate tax, some lawmakers want to put an end to "stepped-up" basis and have the original basis of the property "carryover" to the new owner. Congress actually approved "carryover basis" back in the 1970s, but it was so complicated that it was abandoned before it went into effect.)
The wash-sale rule applies if within 30 days before or after the sale of stock or other securities showing a loss you buy "substantially identical" stock or securities. There's no precise definition of "substantially identical," but the rule clearly puts the kibosh on buying and selling shares of the same company.
Assume you own stock showing a substantial paper loss. Although you have every confidence the shares will recover their value, you sell the stock to realize the loss and trim your tax bill and then buy back the shares so that you can profit if the expected rebound occurs.
It will work, but only if you wait at least 30 days after the sale before you re-buy the shares (or you purchased the replacement stock more than 30 days before the sale). Otherwise, the IRS will ignore the sale and deny the tax loss. It sees the deal as a wash because you wind up with the same stock in your portfolio.
A tax loss is disallowed if within 30 days before or after the sale you buy the same or substantially identical securities. Despite all the similarities between bonds used in bond-swapping, the wash-sale rule will not come into play if different issuers are involved. If you buy bonds of the same issuer, the replacement bonds must have different maturities and coupon rates.
Although you can't claim the tax loss on a wash sale, it's really postponed rather than forfeited. You get to add the disallowed loss to the basis of your newly purchased shares. For example, say you bought 100 shares of XYZ stock for $1,000 and later sell them for $750. Within 30 days of that sale, however, you purchase 100 shares of the same stock for $800. Your $250 loss on the sale is disallowed, but you get to add that amount to the $800 cost of the new stock, giving it a basis of $1,050.
Note that the wash-sale rule applies only to losses. It's okay if you want to sell securities to realize a taxable profit and then turn around immediately and reinvest in the same issues.
You may be able to accomplish your goal of claiming a loss while maintaining your market position without running afoul of the wash-sale rule. Perhaps, for example, you could trade your stock for that of another company in the same industry that's likely to perform similarly. Your broker may be able to offer recommendations. Or, you could sell shares in one mutual fund for a loss and reinvest the proceeds in another fund that has similar objectives and performance history. If you invest in no-load funds, this method avoids the transaction costs that can offset some of the savings when dealing with individual stocks and bonds.
What if you sell stock you don't own, which is exactly what happens in a short sale? An investor borrows stock from a broker in order to sell it, usually with the hope that the stock price will fall. If it does, the investor profits by repaying the loan with shares purchased at the lower price. If the stock price increases, the investor loses and has to repay the loan with shares that cost more than those sold.
As far as the IRS is concerned, the transaction doesn't count for tax purposes until the investor delivers the stock to the lender to close the sale. If you sold stock short in 2005 and close the deal in 2006, for example, the gain or loss will be reported on your 2006 tax return, the one filed in the spring of 2007. The premium you pay the broker to borrow the stock used in the short sale is considered investment interest, which is deductible to the extent of your investment income.
But it doesn't always work that way. Sometimes an investor who owns a certain stock will sell the same stock short, – instead of selling his own shares. That is, the investor borrows shares in the same company he owns and sells the borrowed shares. This is a maneuver called selling "short against the box." That used to be a neat tax trick, attractive especially at year-end because it permitted you to lock in profit on a stock in an uncertain market while postponing recognition of the taxable gain until the following year. You could sell borrowed stock at the current price, but the transaction didn't count for tax purposes until the following year when you delivered your shares to repay the loan. The short sale shielded you from market risk in the meantime. It doesn't work any more. Under the rules now in effect, if you make a short sale of a security you already own, it's considered a sale for tax purposes on the day of the short sale—assuming there's a profit to be taxed.
Q. I invested in a tax-free municipal bond fund for three years, and when I sold it the shares were worth less than what I paid. Can I deduct the loss even though this was a tax-free investment?
A. Yes. If you sold for less than your basis in the shares, you have a capital loss. You can use it to offset any capital gains and up to $3,000 of other income. An exception to this rule won't affect you because you owned the shares for three years. When muni-bond fund shares are owned for six months or less, though, any loss must be reduced by the amount of any tax-free income received from the fund during the time the shares were owned.
Q. I inherited some stock last year and sold it for several thousand dollars. Do I have to pay any tax on the amount I received from the sale?
A. Perhaps, but the sale might actually result in cutting your tax bill. Your basis in the stock—that is, the amount from which you figure your gain or loss—is probably its value on the date the previous owner died. On rare occasions an alternative valuation date is used. In either case, the executor of the estate should be able to pinpoint the value. If you sold the stock for more than that amount, you must pay tax on the difference. If you sold for less, you have a deductible capital loss.
What if a family loan goes sour? Sure, you can count on your daughter the scholar to repay your loans after she gets her Ph.D., but what about your brother-in-law the taxidermist? If he stiffs you, can you write off the bad debt and thereby get Uncle Sam to subsidize your loss?
Perhaps, but the IRS is particularly suspicious of bad-debt deductions when the transaction involves relatives. Whether the borrower is your child or someone else, however, you can earn a bad-debt deduction if you can prove a true debtor/creditor relationship existed and that you fully expected to be repaid. That means you should go through the formalities of drawing up a note specifying repayment terms. If the borrower stops payments, you have to make an effort to collect, enough of an effort that you can convince an IRS auditor that there is no hope of collecting. You also have to be able to show that the debt became worthless in the year that you're claiming the deduction. Did the borrower file for bankruptcy, for example, or skip the country?
Clearly, it's difficult to qualify for a bad-debt deduction growing out of an unpaid family loan. If you can pass the tests, the bad debt is treated as a capital loss and deducted on Schedule D. As with other capital losses, bad debts are deducted first against capital gains and then against up to $3,000 of ordinary income.
Basis is essentially your investment in the property—the amount you will compare to the sales proceeds to determine the size of your profit or loss. The higher you can prove your basis to be the less gain there is to be taxed... and therefore the lower your tax bill.
Although this sounds like a simple concept, it isn't necessarily so. For one thing, your basis depends on how you get the property in the first place. (Although the discussion here focuses on stocks, the same basic rules for basis apply to other investments as well.)
The tax basis of stock you purchase is what you pay for it, plus the commission you pay. Say you buy 100 shares of XYZ Inc. at $40 a share, and you pay a $100 commission. The total cost is $4,100, and the tax basis of each of your shares is $41. If you sell the 100 shares for same $40 each, and pay $100 commission on the sale, you have a $200 loss—your $4,100 basis minus the $3,900 proceeds of the sale.
The basis of securities you receive as a gift depends on whether your ultimate sale of the stock produces a profit or loss. If you sell for a profit, your basis is the same as the basis of the previous owner. In other words, the basis is transferred along with the property. If you sell for a loss, though, the basis is either the previous owner's basis or the value of the stock at the time of the gift, whichever is lower. In other words, you don't get to write off a loss that occurred while the donor owned the securities.
When you inherit stock or other property, your basis is usually set at the value of the asset on the date of death of the previous owner. Assuming the asset had appreciated, the basis is "stepped up" to market value, so the income tax on any profit that built up while the previous owner was alive is forgiven. You are responsible only for the tax on appreciation after you inherit the stock. If the stock price falls before you sell it, you can claim a tax loss.
(There is an exception to the general rule, which applies only when an estate is large enough for a federal estate tax return to be filed. In this case the executor can set the basis of the property at its value six months after the owner died, or when it was sold, if it was sold during that six month period. If the executor of the estate chooses that value for estate-tax purposes, it becomes your basis in the stock.)
If you own stock or other assets with a spouse as joint tenants or tenants by the entirety (forms of ownership that insure that on the death of one co-owner the survivor becomes the sole owner) the basis is adjusted upward on the death of the co-owner. Basically, the survivor is treated as though he or she inherited half of each share of stock, with its basis increased to current market value.
In a community-property state, the entire basis of community property—not just half—may be increased to date-of-death value upon the death of one spouse. Since that could have a major impact on the taxes due when the stock is sold, check this point carefully if you live in one of these states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin.
When unmarried individuals own property in joint tenancy, each owner's share of the property—and therefore the part of the basis that's stepped up when that owner dies—is determined by contribution to the purchase price. Suppose you and your brother buy a cabin, with you contributing 20% of the cost and him paying the remaining 80%. If he dies first, 80% of the basis would be stepped up. Your basis would become your original investment, plus 80% of the cabin's value at the time of his death.
When a survivor can't prove his or her contribution, the IRS assumes the deceased owner provided all of it. This rule works in the IRS's favor as far as estate taxes are concerned because the full value of the property must be included in the estate of the first joint owner to die. But it backfires for the IRS when it comes to the basis because the entire amount is stepped up.
The step up is enormously valuable, but some taxpayers may unknowingly forfeit it by selling highly appreciated assets late in life, perhaps in an attempt to simplify their affairs. And, even when the basis should be stepped up because property is held at the time of death, the savings might elude survivors. It is up to the heir to use the higher basis when the inherited property is sold. If you don't know the rules, you could wind up overpaying your taxes.
To protect yourself, make sure that the basis of any property you have inherited has been properly stepped up. How do you set the value? For publicly owned stocks, find the price on the date of death of the previous owner by visiting a library that has The New York Times or The Wall Street Journal on microfilm or cd-rom. You may also be able to find the information on the company's website or by checking historic prices at a Website such as www.bigcharts.com.
Other kinds of property—such as real estate and antiques—should have been valued at the time the estate was distributed. Ask the executor. If he or she can't help, ask an accountant or attorney experienced with estates for help establishing the proper basis.
What if you have already sold inherited property, figured the gain on an un-stepped-up basis and overpaid your tax? If the return is still open to amendment (as it is for three years after the date), you can reclaim your money by filing an amended return using Form 1040X.
When it comes to the holding period the sale of inherited property always produces a long-term gain or loss.
Thanks to the tax law, in a divorce settlement one piece of property can be worth far more than another with exactly the same market value. The reason is that when property changes hands as a result of a divorce—whether it is the family home, a portfolio of stocks or other assets—the tax basis of the property also changes hands. The basis is the amount from which gain or loss will be figured when the property is sold. Because the new owner gets the old owner's basis, he or she is responsible for the tax on all the appreciation before as well as after the transfer.
This rule means you have to look carefully at the tax basis of property that may be part of a settlement. For example, $100,000 worth of stock with a basis of $90,000 is worth significantly more than $100,000 worth of stock with a $50,000 basis. The maximum tax on the sale of the first stock would be $1,500 (15% of the $10,000 gain). The tax on the sale of the second block of stock could be as high as $7,500 (15% of the $50,000 gain).
When a company in which you own stock declares a stock split, your basis in the shares is spread across both the new and old shares. Say you own 100 shares with a basis of $10 each in a firm that declares a two-for-one split. Your total basis of $1,000 (100 x $10) would be spread among the 200 shares, giving each share a basis of $5.
Your basis in shares purchased through a dividend-reinvestment plan is the stock's cost. Thus, if you have $500 in dividends reinvested and it buys you 30 additional shares, your basis in each share would be $16.67 ($500 divided by 30).
Except for money-market funds, in which the value of shares remains constant, the price of mutual-fund shares fluctuates, just like the price of individual stocks and bonds. When you sell shares, you need to know exactly what your tax basis is to pinpoint the taxable gain or loss. Because redemptions can produce short- or long term-results, you also need to track the holding period of all shares you own.
Set up a separate file for each fund you invest in and faithfully keep it up to date. Beyond simplifying your life at tax time, there's a good chance thorough records will save you money.
As with individual stocks, your basis in the shares begins as what you pay for them. If you invest in a no-load fund (one free of a sales commission) your basis is the same as the share's net asset value on the day you buy. If you buy into a load fund, your basis includes the load charge.
Your basis in the shares can change while you own them, too. On rare occasions, funds declare capital gains but retain the profits and pay tax on them rather than distribute the profit to shareholders. Such undistributed capital gains increase your basis in fund shares and complicate your tax return.
If your fund does this, you'll receive a Form 2439 showing your share of the undistributed gain and your portion of the tax bill the fund paid on the gain. You have to report the undistributed gain as taxable income —even though you didn't get it—but you also get to claim a tax credit for the amount of tax paid by the fund on your behalf. The interview asks if you received a Form 2439. When you report the amount shown on the form, the program automatically enters the credit on the Form 1040. You also increase the tax basis by the difference between the undistributed gain you report and the credit you claim. That might appear to be a hassle, but remember that hiking your basis will trim the tax bill due when you ultimately sell your shares.
You need to keep a running tally of your investment in the fund. If you liquidate your entire investment at once, your gain or loss will be determined by comparing how much you get with how much you paid for every share you own, whether purchased outright or via dividend reinvestment. By keeping track of all those dividend reinvestments, you'll be sure not to pay more tax than you owe.
If you sell only some of your shares, your recordkeeping can pay off handsomely. In choosing which shares to sell, you can pick the ones with the basis and holding period combination that produces the best tax result. Assuming all your shares have appreciated and you've owned all of them for over 12 months, if you sell those with the highest basis, you will wind up with the lowest taxable gain. If other investments have produced capital losses, however, you may want to sell low-basis shares to take a bigger profit for the losses to offset.
Since your shares are pooled in a single account by the mutual fund, who knows which shares are sold and which retained? You do, if you keep good records. If you direct the fund to sell specific shares—such as the 100 shares purchased July 3, 1997, for $27.85 a share—it's the basis of those shares that determines the tax consequences of the sale. You should keep records of your sale order, including a copy of the letter to the fund identifying the shares to be sold by the date you acquired them and the price paid. You should also ask the fund for a letter confirming your specific directive, and keep that letter in your files, too.
If you simply call or write the fund and ask that a certain number of shares be redeemed without specifying which ones, however, it is assumed that the first shares sold are the first ones you bought.
The IRS does permit mutual fund investors to use an "average" basis for figuring gain or loss on the sale of fund shares. There are really two average basis methods—single- and double-category. This discussion focuses on the single-category method, which is the easier and most used. The double-category method, which involves dividing shares depending according to how long they have been owned, is almost always more trouble than it's worth.
With the single-category method, you add up your total investment in the fund (including all those bits and pieces of reinvested dividends), divide it by the number of shares you own and, voila, you know the average basis. That's the figure you use to calculate gain or loss on sale. If your investments over the years result in a $22.48 average basis and you redeem 100 shares at $25 a share, for example, you'd have a $252 gain ($2,500 minus $2,248). When it comes to determining whether a gain or loss is long- or short-term, you assume the shares sold are those you've owned the longest.
The single-category method is gaining more and more converts because an increasing number of funds is actually doing the work for shareholders. The funds send out an extra statement each year—a copy of which does not go to the IRS—showing the average basis of shares redeemed during the year.
You can switch between specific identification and FIFO whenever you wish, but once you use the average basis method for a fund, you're stuck with it for as long as you own shares in that fund. IRS Publication 564, Mutual Fund Distributions, explains the average basis method in more detail. If it's not included in your edition of TaxCut, you can get a free copy by calling 1-800-TAX-FORM or download a copy from the IRS website.
Receipts from garage sales are not taxable, except in very unusual circumstances where an item sells for more than you paid for it. Otherwise, you can pocket the money in good conscience.