April 15th, 2010 
Vijaianand Previously, we discussed about the difference between Tax preparation and Tax planning. We saw few examples of simple tax planning strategies which can be adapted to save money. In continuing witth the tax planning topic, this post we will learn about Cost basis and stock selling strategies with examples that can help you either get more refunds or save paying more taxes.
What is Stock/Security Cost Basis?
There are actually various different cost basis involved in any investments including stocks. Let see the importance and their role in tax planning.
The Starting Cost basis is actually what a person pays for the purchase of the stock initially, adding any cost of purchase such as commissions. If the person received the stock as an inheritance, the starting basis is the value of the stock on the date the original owner died. This is called a stepped-up basis. Stepped basis is when the donee(who recieves the stocks) gets the FMV (fare market value) as their starting basis instead of donor’s original basis.
If the stock is given as a gift, the starting basis is the lesser of either:
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the starting basis of the person who gifted the stock(carryover basis), or
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the market value of the stock on the date the gift.
Why cost basis important?
When you purchase/inherit/get gifts of stocks/securities, starting cost basis is set accordingly. When those stocks or other securities are sold, the selling price is usually different from the original purchase price of the shares. Either a capital gain or a capital loss is realized during this transaction and must be reported to the IRS by the taxpayer. In order to calculate the amount of capital gains and losses the cost basis of the stock must be determined.
Whether it is a short term or long term capital gain depends on the holding period of the stock/securities. We will discuss about that more later.
There are three different ways to find the cost basis when selling stocks:
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First in first out (FIFO)
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Average cost method
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Specific share identification
First in first out (FIFO) method uses the shares first purchased as the cost basis. This method is effective if the first shares purchased were the most expensive.
The cost of shares is used in the order purchased for determining cost basis according to FIFO method. The oldest shares owed are considered to be the ones that are sold first. This method is the default method that the IRS will assume a taxpayer is following unless otherwise specified in a statement attached to the income tax return.
For example, Investor John buys the following round lots of Apple, Inc.:
- 200 shares on January 3, 1999 at $71.50/share
- 300 shares on September 5, 2007 at $160.50/share
- 200 shares on Apr 20, 2009 at $120.50/share
On September 15, 2010 she sold 400 shares at $200/share. What is her cost basis according to the FIFO method?
According to FIFO, she would exhaust the basis of the shares purchased the earliest first:
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200 shares at $71.50
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200 shares at $160.50
So the gain/loss for this sale was:
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200 shares ($200 – $71.50) = $25,700
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200 shares ($200 – $160.50) = $7,900
Net gain for the sale = $33,600.
Since all 400 shares were held over a year, the $33,600 gain would be subject to long-term capital gains taxes.
An example of basis in which a gift results in a gain would be as follows:
Ronald gives Jen a round lot of stock as a gift. Ronald paid $10,000 for the stock, and the fair market value (FMV) of the stock is $20,000 at the date of the gift. If Jen sells the stock for $20,000 she will use Ronald’s starting basis of $10,000 is used to report the capital gain.
However, the example above does not apply if Ronald had gifted his stock to Jen when its FMV was $8,000, which is less than his original basis of $10,000. The capital gain or loss reported by Jen depends on whether she subsequently sells the stock for a gain or a loss.
Let’s look another example in which the same gift could result in a loss:
If Jen sold the stock for $15,000 then Jennifer would report a capital gain of $5,000 using Ronald’s original basis of $10,000 to calculate her gain. However, if Jen sold the stock for $5,000 she would report a loss of $3,000 using the stock’s FMV basis of $8,000 to determine her loss. Note that if Jen sold the stock for $9,000 she would not report a gain or a loss in this situation.
Tax Planning Tips:
As per the FIFO method, first purchased stocks are used to calculate the cost basis. If they are purchased cheap, tax liability will be more and you will end up paying lot more in taxes. At the same time, if you are selling for loss, you might get big tax loss deduction. FIFO method is the default method used by any brokers unless you inform them to use different method for sell.
When it comes to gifting, tax planning should be key as well. What to gift, when to gift and how to gift them are important points. If you keep appreciated security and donee sells it immediately, he will end up liable for the big capital gain.
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In my last post, I stressed the importance of timely action on your 401K before it’s too late whether you decide to save or take out distributions. How you handle your 401-K account can result in anywhere from zero to hefty taxes and penalties. This blog post, I plan to share few important questions and answers with my research, study and experience in rolling over 401K during the job change 2 years ago.