A new tax law took effect on Jan. 1, 2011 as a part of the Emergency Economic Stabilization Act of 2008, and it requires brokerages to report certain cost basis information to the IRS. This is a good thing for investors because it makes tax preparation easier and places more responsibility on your brokerage to accurately track your cost basis.This tax legislation impacts your brokerage account in a number of ways, so check with your brokerage to find out more. For example, Scottrade streamlined their information into an easy-to-use online Cost Basis Education.

What is Cost Basis?

Let’s back up for a moment and define cost basis. Cost basis is the original value of an asset that is used to calculate gains and losses for tax purposes. For most positions, your cost basis will be the purchase price plus any commissions, and it will be adjusted for wash sales, corporate actions and/or return of capital during the time you hold it.

Cost Basis Reporting

The new legislation rolls out in phases. This tax year, your brokerage will report to the IRS the cost basis for all equities you acquired on or after Jan. 1, 2011. These are called “covered” positions. All your other investments, including equities purchased before 2011, are considered “non-covered” positions. Equities include stocks, American Depositary Receipts (ADRs) and Real Estate Investment Trusts (REITs).

Over the next two years, other types of investments will be covered:

Where Cost Basis is Reported

Your cost basis information will appear on your Form 1099. Keep in mind that not all brokerage accounts will receive a Form 1099. To learn more about the different tax forms generated for brokerage accounts, check out last month’s blog, What to Expect from Your Brokerage at Tax Time .

 Capital Gains & Losses

Cost basis information is used by your brokerage and the IRS to calculate capital gains or losses when you close a position. Some brokerages, like Scottrade, allow you to choose how your capital gains and losses are calculated.

For example, Scottrade’s default calculation method is first-in, first-out (FIFO), which means the first shares you acquired will be the first sold. Think of it like the milk aisle at a large grocery store – the shelf is loaded back-to-front from the refrigerated room in back, so the first gallon of milk that the grocer slides into the shelf is the first one a customer sees. The first gallon of milk put in is the first gallon of milk that is taken out.

Shares of stock can work the same way. Here’s an example:

Monday:         Buy 50 shares XYZ @ $9 ($450 total)

Wednesday:   Buy 50 shares XYZ @ $11 ($550 total)

Thursday:      Buy 50 shares XYZ @ $10 ($500 total)

Friday:            Sell 50 shares XYZ @ $10 (500 total)

With FIFO, your total realized gain would be $50. The first shares you bought (50 @ $9 on Monday) would be the first shares sold. Subtract your investment of $450 from your sale price of $500, and you gained $50 on the transaction.

FIFO is one of several calculation methods your brokerage can use. Check with your brokerage to find out more about the methods available and how to set a tax strategy in your account.

To learn more about cost basis, visit Scottrade’s Cost Basis Education.

Scottrade does not provide tax advice. The material provided in this article is for informational purposes only and Scottrade is not responsible for any errors or omissions. Please consult your tax software or tax/legal advisor(s) for questions concerning your personal tax or financial situation.

Jaci Devine is a free-lance writer with experience in the financial services industry who specializes in investment education.

Capital Gains Tax

A capital gain is the profit made when you sell an investment for more than what you bought it for. If your investments sell for less than you bought them for, then you
are entitled to claim a capital loss. If you have incurred capital gains this year, and you have some losing investments in your portfolio, consider harvesting some of those losses to offset the gains so you won’t owe taxes on the capital gain income. Here’s where to start:

Compute the gains on assets you’ve already sold.  Make a list of your sales of stocks, bonds and real estate during the year, and add expected capital gain dividends on mutual funds.

Offset any losses you have already realized this year. That includes the stock you purchased when it was high and you thought it would go higher, but you finally sold when it dropped well below what you paid for it. Don’t forget loss carryovers from prior years – you can spot carryovers on page 2 of last year’s Schedule D of your personal income tax return.

If the gains exceed the losses, look for unrealized losses to offset those gains.  You may be holding onto a stock that has dropped, hoping it will regain its value. This may be a good time to sell the stock and put that loss to work.

Check your income tax bracket.  Before taking the step to sell a stock that has dropped in value, also see if you can take advantage of lower capital gains rates, which were extended until the end of 2012.  The maximum capital gains rate for most people with long-term capital gains is 15%.  If you have income lower than $34,500 ($69,000 for married filing jointly), capital gains and dividends may be taxed at 0% depending on the type of net capital gain!

Beware of the wash sale rule.  You cannot deduct losses from sales in a wash sale.  A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale, you buy substantially identical stock, acquire identical stock or securities in a fully taxable trade, acquire an option to buy substantially identical stock, or acquire substantially identical stock for your IRA.

Tip:  If you have a disallowed loss from a wash sale, add the disallowed loss to the cost of the new stock or securities.  The result will increase the cost basis of your new stock and decrease your gain on the sale of the new stock.

Don’t harvest too many losses.  Once you have offset your losses against your gains, excess losses can reduce up to $3,000 of ordinary income from employment or other sources. If your losses are greater than that, the excess can be carried over to the next year.

TurboTax easily guides you through the necessary interview questions and accurately makes the behind the scene calculations for your capital transactions.  You can also use tax calculators to help you plan and work through various tax scenarios.

But if you are selling your current home so you can buy another one, the buyer’s market may work against you on the sale side due to fewer customers and customers’ ability to offer lower prices for your old home. If it takes longer to sell than you expected, the timing may be troublesome: sell your old home before you find a new one, and you’ll be scrambling to find a new home and may find yourself settling for the not-so-perfect house. Buy first, before your old home has sold, and you’ll be under the gun to sell your old home, and might not be able to hold out for the best price.

Try making your purchase offer contingent on you selling your old home – that may work if you can demonstrate to a seller that there’s a good chance your house will sell quickly. And be sure to get qualified with a mortgage company before you shop so that you have the financing in place and know how much house you can afford.

If you find the perfect new home and want to close on it before the old one sells, how do you bridge the financial gap? If your old house has plenty of equity, and you have enough income to pay two mortgages, you may take out a bridge loan, which is a short-term loan using your old home as collateral. That will give you the funds you need to close on the new house, and the bridge loan will be paid off when you sell the old home. Or you can borrow from family or friends who are well-heeled, if you have any in that fortunate position who are willing to help.

If you’re lucky enough to make that purchase happen, you may benefit from more tax deductions. You get a tax deduction for interest paid on your mortgage, but what about the bridge loan and the loan on the new residence that you buy while waiting for the old residence to sell? Good news. Interest on loans for the purchase or improvement of up to two residences is deductible, so it is likely that you can deduct the interest on both mortgages and the bridge loan. And property taxes are deductible on all properties that you own as well.

Capital gains on the sale of your home may also have tax consequences. Ordinarily you would owe tax on the difference between the net sales price and your cost basis, but most home sellers don’t owe tax — since 1987, homeowners have been able to exclude most or all of the gain when they sell.

The general rule is that if you sell your primary residence, you can exclude a gain of as much as $500,000 if you’re married and filing a joint return with your spouse, or $250,000 if you’re single or married filing separately. To be eligible for the full exclusion, you must have owned the home and lived in it as your principal residence for at least two of the five years prior to sale.

If you have to sell your home but you’ve owned it less than two years, all is not lost. You can claim a reduced exclusion if the sale occurred because of a change in your place of employment, health reasons or “unforeseen circumstances” such as divorce, multiple births or job loss. So if you’ve owned and lived in the home for just 18 months when you sell, not 24 months, then 18/24 or 75% of the $250,000 per person exclusion would apply.

Most taxpayers are fortunate enough not to owe taxes when they earn money on the sale of their principal residence, but what about selling at a loss? Unfortunately, you can’t claim a loss from the sale of your principal residence.

• Salary or hourly wages
• Interest income
• Self-employment income (e.g., freelancing or otherwise running your own business)
• Rental income

Capital gains income result from the selling of certain items for more than you paid for them.  Examples of transactions which often trigger capital gains include:

• Stocks sales
• Mutual fund sales
• Home sales

There are two kinds of capital transactions: short-term and long-term. Short-term transactions occur if the sale happens a year or less after the purchase. Short-term capital gains are taxed as ordinary income. However, long-term capital gains (where the taxpayer owned the asset for more than one year), are taxed at capital gains tax rates.

At most times in our history including today, top ordinary income tax rates exceed top capital gains tax rates. Consequently, you’d prefer income from a capital gains transaction over the same event triggering ordinary income.

Calculating Capital Gains Tax

To determine the extent of a capital gain or loss, you simply subtract your basis in the asset you sold from its sales price. If your basis is less than the sales price, you have a capital gain. If your basis exceeds your sales price, you have a capital loss.  Let’s take an example.

Say you sold 101 shares of the stock HLMA on November 10, 2010 for $15/share.  You used a discount broker, so your commission on the trade was just $7.  The net proceeds from the stock sale are $1,508 ((101 shares x $15 price) – $7 commission).

You originally purchased 100 shares on April 26, 2008 for $12/share also paying a $7 commission.  Your total purchase price is $1,207 ((100 shares x 12 price) + $7 commission).

Since you paid $1,207 for a stock you sold for $1,508, you have a capital gain of $301 ($1,508 – $1,207), right?

While many would calculate their gain that way, it might lead to an overpayment of tax, because your basis is not always exactly equal to your purchase price. Perhaps you noticed our example features a sale of 101 shares but a purchase of only 100. Where did the other share come from? It turns out HLMA paid a $20 dividend on December 13, 2009. At that time, HLMA was trading for $20/share (Yes, last December would have been a better time to sell our fictional stock but, alas, there is no crystal ball). Upon your instructions, your broker took the $20 dividend and bought another share of HLMA, otherwise known as reinvesting your dividend.

When you calculate your basis in the HLMA stock you sold, add the $20 to your basis. Therefore, your total capital gain is actually $281 ($1,508 sales price – $1,227 basis).  Your capital gains tax rate currently varies based on your total income, but the highest current rate is 15%, so the most tax you’d owe on this hypothetical stock sale is $42.50 (15% x $281 capital gain).

Note:  the maximum capital gains tax rate is set to rise to 20% on January 1, 2011. Whether and to what extent tax legislation passes affecting 2011 tax rates is currently anyone’s guess. Hmm, sounds like a future blog posting at the TurboTax blog.

Not necessarily.

There’s nothing to report on your tax return if your investment lives — like most everyone’s does — in a 401(k) or an IRA. These are special no-taxes zones, where you can buy and sell securities and mutual funds without having to report the capital gains and losses on your tax return. When you eventually take your money out, however, you’ll have to pay income taxes on some or all of it (unless it’s coming from a Roth IRA.)

Stocks/Investments

But what about the investments you own outside of your retirement accounts?

Let’s say your 200 shares of the Bank of What Was I Thinking have fallen by 50 percent.

You can’t deduct your loss, however, if you haven’t sold those shares. Until you sell, you have what’s known as a “paper loss,” not an actual loss.

Now then, even if you sold your shares after watching them lose half their value, you still might not get to claim a loss. Let’s say you bought the shares at $50 each, they climbed to $140, then fell to $70 at which point you decided to sell them. However, you don’t have a loss. You have a gain of $20 per share. And you need to report that on your tax return.

Here’s another puzzler. You might have a taxable gain even if you didn’t sell any of your investments. How is that possible?

Because a mutual fund you own sold some stocks and bonds it had in its portfolio. Here’s what happens when the markets climb steeply then fall precipitously, as they did in recent months:

When the markets were booming, your mutual fund held stocks that had shot up value. And when the markets fell, some investors decided to bail. The managers of your mutual fund had to pay those investors, so the managers sold highly appreciated stocks to raise the cash. That generated capital gains for the mutual fund, which are passed on to you as capital gain distributions.

Unless, of course, your mutual fund is in your retirement account. You don’t have to report your “gain” to the IRS.

For more information on about taxes and your investments, read Capital Gains and Losses.