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“What’s the basis, Kenneth?” Calculating gain on sales of stock

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The New York Times has an AP release up entitled “Using Tax-Prep Software? Trust Results but Verify”. Interpreting the typical 1099-Combined that taxpayers get from their brokerage house can be tricky, and downloading the info from your broker into your tax prep software can be even trickier. By far the largest number of post-April 15 problems that we see have to do with misreported stock transactions.

The basic problem, as the referenced article notes, is this:

brokerages aren’t currently required to provide cost data (e.g. your basis in the stock), and software simply reflects the information it’s given, it’s up to filers to make sure the results of the import are accurate.

At its core, calculating your cost basis is simple. You take the amount that you paid when you purchased the stock, plus any commissions that you paid to the brokerage firm, and you have your basis. Once you have the basis, the amount of your capital gain is the amount for which you sold the shares (less any commissions received by the brokerage firm), minus your basis.

Where it becomes tricky is when you purchase shares of stock at different times and for different amounts. Unless you (or your agent) designates specific shares of stock to be sold, the IRS requires you to use the FIFO method (first in, first out) to determine which shares were sold – which means that you sell your oldest shares first. You also have to take into consideration such things as stock splits (which reduce your basis per share but not your total basis) and reinvested dividends (which add to the number of shares that you own).

Let’s walk through a case study:

1/1/2008: purchase 100 shares of company XYZ at $10 per share, $25 brokerage fee
12/1/2008: company declares a dividend of 50 cents per share, reinvested in stock at $20 per share (no fee). You now own 102.5 shares ($50 dividend on your 100 shares reinvested at $20 per share)
5/1/2009: broker purchases an additional 100 shares at $15 per share, $25 brokerage fee
11/1/2009: you sell 150 shares at $17 per share. $25 transaction fee.

Using FIFO, you sold:
100 shares from the first purchase, basis $1025 (100 * 10 + 25)
2.5 shares from the reinvested dividend, basis $50
47.5 shares from the final purchase, basis $724.38 (47.5 shares at a basis of $15.25 per share, calculated from the $1525 you paid for 100 shares)

So your total basis in the shares that you sold is $1799.38. However, because you sold 100 shares that you held for more than a year, and 50 shares that you held for less than a year, you have to allocate the basis and the sale proceeds between long-term and short-term for purposes of calculating gain.

Your net proceeds from the sale were $2525 ($2550 for 150 shares at $17 per share, less the $25 brokerage fee). Of that $1683.33 is allocated to the 100 shares held long-term, and $841.67 is allocated to the 50 shares held short-term. Your gains, then, are:

long term $658.33 ($1683.33 – $1025 basis)
short term $67.29 ($841.67 – $50 basis on the reinvested dividend – $724.38 basis on the remaining 47.5 shares)

Fun, yes? Chances are that if you imported your information from the brokerage house into your favorite tax prep software -as the referenced article notes – the basis information would either be missing or incorrect.

The good news is that many brokers, including most of the major ones, report basis as well as proceeds on the Combined 1099, so you should be able to figure it out. The better news is that by 2012 stock brokers and mutual fund companies will be required to report cost basis to their investors, and to the IRS – so that you’ll ALWAYS have the basis handy on the 1099.

As always: if you are not sure you have it right, contact a reputable tax advisor in your area. IRS looks closely at Schedule D transactions; if you have it wrong, you are almost guaranteed to get a letter from them, and it’s better to be sure before you have to pay penalites and interest rather than after.


Written by nctaxpro

February 27, 2010 at 10:45 am

Posted in Federal, Taxes

One Response

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  1. […] “What’s the basis, Kenneth?” Calculating gain on sales of stock « Growing Wi… […]

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