Taxation of Security Transactions

When securities are sold by an investor rather than by a trader conducting his trades as a business, there is either a capital gain or loss. If the holding period for the security exceeds 1 year, then the capital gain or loss is long-term; otherwise, it is short term. Short term gains are subject to the ordinary income tax rate, while long-term gains are subject either to the 0% rate for those who are in the 15% bracket or less, 15% for those in the other brackets below the top bracket or the 20% rate for those in the 39.6% bracket. Additionally, taxpayers with incomes of at least $200,000 ($250,000 for joint filers) must also pay the new 3.8% Medicare surcharge on net investment income. Up to $3000 ($1500 if married filing separately) of capital losses can be deducted from other sources of income, such as wages. Any nondeductible losses can be carried forward.

Tax Basis of Securities: Determining Profit or Loss

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Profit or loss from the sale of securities is generally determined by subtracting the tax basis in the securities from the sales proceeds of the transaction. The main component of the basis is the purchase price plus any direct costs of buying, such as brokerage commissions. The direct costs of selling are subtracted from the selling price of the transaction.

So if you use a discount brokerage that charges only $4 to buy and sell securities, and you buy 100 shares of ABC stock for $10 per share, then your adjusted basis in the stock is $1004. If you sell the stock later for $14 per share, then your profit is equal to the $1400 sale price minus the $4 selling commission minus your stock basis of $1004: Profit = $1396 – $1004 = $392.

If the securities were received as a gift, then the donee acquires a carryover basis from that of the donor. If the securities were inherited, for any year other than 2010, then they receive a stepped-up basis, equal to their fair market value on the day of the donor's death. If the donor died in 2010, then, like gifts, the donee receives a carryover basis equal to the donor 's basis. Whether the securities were received as a gift or as an inheritance, the holding period for the donee begins when the donor acquired the securities.

So if your father gave you securities that he has held for 1 year and you sell it 6 months later, then your holding period will be for 1½ years, so the gain or loss will be a long-term capital gain or loss.

Moreover, dividend reinvestments are added to the tax basis of acquired shares, since the shareholder must pay tax on any cash dividends when earned, whether the dividends are reinvested or not.

For stocks acquired after 2010 or mutual fund shares acquired after 2011, brokerage firms will be required to report to the IRS the tax basis of the shares sold, if known. The sale of securities by investors must be reported on Form 1040, Schedule B, Capital Gains and Losses. Capital losses are limited by the $3,000 rule [IRC §1211(b)] and the wash sale rules. If the securities were acquired before their basis was legally required to be reported by the broker, then the taxpayer is required to keep evidence of the basis in those securities; otherwise, the IRS may assume a zero basis, resulting in a larger taxable gain, unless the basis can be reconstructed by supporting evidence. The proof of basis is on the taxpayer.

Although security transactions are typically settled by the 3rd business day after the trade date, it is the trade date that determines the year in which the transaction took place. So stock that was sold on December 30, 2015 must be reported for the 2015 tax year, even though the settlement date would be in 2016.

Identifying Stock Lots

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If a taxpayer has bought stocks or other securities of a similar type at different periods of time and at different prices, then the IRS assumes that when the security is sold, the first one bought is the first one sold – in other words, the IRS presumes a first-in, first-out (FIFO) rule. If the taxpayer wants to treat the transaction differently, then he must identify the specific stock sold by using one of the methods acceptable to the IRS. If the securities are registered in the taxpayer's name, then identifying the securities with the CUSIP number of the security, which is a 9 character number that uniquely identifies virtually every security traded, is sufficient. If the securities are held by a broker in a margin account, then they are said to be held under the street name of the broker. If a taxpayer wants to sell a particular block of stock, then he must inform the broker and the broker must give written confirmation for the particular lot sold. The IRS will not accept a statement from the taxpayer regarding the identification of the stock sold.

When new certificates are given in exchange for old certificates, then the CUSIP numbers of the new certificates should be identified with the CUSIP numbers of the old certificates. This method would be used, for instance, for a stock split. When a company pays a stock dividend, then the stock dividend is considered part of the lot owned by the taxpayer for which the stock dividend was paid. If the taxpayer has more than 1 lot, then the FIFO rule applies. If the stock is acquired by exercising stock rights, then the stock is considered acquired on the date of subscription.

Unlike mutual fund shares, shares of stock cannot be averaged, so the FIFO rule will apply unless the lots are specifically identified.

Example: You purchased 100 shares of XYZ stock for $10 a share, then later, purchased another 200 shares for $12 per share. Later, you sell 200 shares of the stock for $15 per share. Therefore, your profit is:

Stock Dividends

Sometimes a dividend is paid with additional stock rather than cash. Most of these stock dividends are nontaxable, and the holding period of the stock acquired as a dividend begins when the original stock, on which the dividend was paid, was acquired. The reason for this is because a stock dividend or a stock split does not increase the value of the company; rather, it decreases the value of each stock. For this reason, the tax basis of the new stock is calculated thus:

Tax Basis of Each Share of Stock =Tax Basis of Original Stock
Number of Shares of Original Stock + Number of Shares of Stock Dividend

Example: you purchased 100 shares of XYZ stock for $1000. Later, you receive a 10% stock dividend, equal to 10 shares of stock. Therefore, your tax basis in each share of stock is equal to $1000/(100+10) = $9.09

If the tax-free dividend is paid with a different class of stock, such as preferred stock, then the tax basis of the old stock will be equal to its market value at the date of distribution divided by the market value of the old stock plus the market value of the new stock. This yields a percentage of the tax basis that is allocated to the original stock as a percentage of the original cost.

Tax Basis of Each Share of Old Stock =Original Cost of Old Stock×Market Value of Original Stock at Distribution
Market Value of Original Stock + Market Value of New Stock

The tax basis of the new shares is equal to their market value on the date of distribution divided by the total market value of the original stock and the new stock, which yields a tax basis as the percentage of the original cost of the stock.

Tax Basis of Each Share of New Stock =Original Cost of Old Stock×Market Value of New Stock at Distribution
Market Value of Original Stock + Market Value of New Stock

Generally, if a company gives the stockholder a choice of a cash dividend or a stock dividend, and the taxpayer chooses the stock dividend, then it becomes taxable, because the taxpayer forfeited the right to receive cash instead of stock. The tax basis of the taxable stock dividend is the fair market value on the date of distribution, which is also the start of the holding period for that stock.

Stock Rights

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Generally, stock rights are given to current stockholders as a way to for them to maintain proportionate ownership of the company. They can choose to exercise the rights by acquiring more stock, usually below market value, they can sell the rights, or they can simply let the rights expire worthless. If the rights expire worthless, then there is no deductible loss since the stockholder did not pay anything for them. If the stock rights are sold, then the sale proceeds is equal to the selling price minus selling expenses, and the holding period is considered from the date of the acquisition of the original stock on which the rights were distributed.

If the rights were purchased, then the tax basis is the price paid plus buying expenses, and the holding period begins the day after the date of the purchase. If purchased rights become worthless, then the stockholder can deduct the loss. If the rights become worthless in the year before they expire, then the taxpayer can take a capital loss in the year that they became worthless.

If the stock rights are exercised, then it is not taxable. Gain or loss is only recognized when the acquired stock is sold. However, the holding period begins when the rights are exercised and the tax basis for the new stock is the subscription price plus the tax basis for the exercised rights.

The tax basis of nontaxable stock rights depends on the fair market value on the date of distribution. If the market value is 15% or more, then the tax basis of the old stock and the rights is equal to their fair market value on the date of distribution. If the market value is less than 15%, then the tax basis of the rights is considered zero unless the taxpayer elects to allocate basis between the original stock and the stock rights. The election must be made in the year that the rights are received by attaching a statement to the tax return electing to divide up the basis. However, the tax basis does not have to be adjusted if the stock rights become worthless in the year of issue.