Regarding taxes, there is a saying to the effect that “those who keep records win.” If you are an investor, you may have a variety of securities, including stocks, bonds, and mutual funds. When you sell those securities, you want to minimize your gains or maximize your losses for tax purposes. Gains or losses are measured from your tax basis in the investment (asset), making it important to keep track of the basis in all of your investments.
What is Basis? Generally, your basis in an investment begins with the price that you paid to purchase the investment. However, this will not be the case if the investment was acquired as a gift or through an inheritance For inherited assets, the basis generally begins with the FMV of the asset on the decedent’s date of death or an alternative valuation date, if chosen by the executor of the estate (special rules not covered in this article apply to property inherited from a decedent who died in 2010, if the executor elected the “no estate tax” provision. In such cases, the executor will have advised the beneficiaries of the basis of each inherited asset.)
Assets acquired as gifts actually have a basis for gain (the donor’s basis) and a basis for loss (the fair market value of the asset on the date of the gift). When an asset is acquired through a division of property in a divorce, the asset retains the basis it had when it was owned jointly by the divorcing couple.
Basis is not a fixed value; it can change during the time an asset is owned and is adjusted by certain events. For an investment asset, these events include:
- Reinvested cash dividends
- Stock splits and reverse splits
- Stock dividends
- Return of capital
- Additional investments
- Broker’s commissions
- Interest previously taken into income under an election under the accrued market discount rules
- Interest taken into income under the original issue discount rules
- Attorney fees
- Acquisition costs
- Casualty losses, etc.
These events can increase or decrease the tax basis of an investment, which makes adequate recordkeeping very important.
Another issue associated with basis arises when only a portion of an investment is sold. For example, in a scenario where 100 shares of a particular stock were purchased in 2008 at $10 a share and another 100 shares in 2010 at $20 a share, and the investor plans on selling 100 shares of the stock at $30 a share, using the general rule of “first in – first out,” there would be a $20 per share gain. However, if the investor can identify each specific block of stock sold, such as the 100-share block purchased in 2010, there would only be a $10 per share profit. This is known as the “specific identification” method.
Beginning with stock purchased in 2011 and mutual funds purchased in 2012, stock brokers are required to keep records of investor purchase prices and report them to the IRS when stocks or funds are sold. If an investor switches brokers, the former broker must pass this information over to the new broker. However, there will still be instances when the basis in the broker’s records may not be accurate. For example, if stock was acquired in a joint account and one of the owners dies, the basis is adjusted as of the date of death. If the broker is unaware of this change, the amount reported to the IRS will be incorrect. Additionally, for purchases made prior to 2011 (or 2012 for funds), the broker is not required to report the basis to the IRS, but many brokers do provide an annual schedule of realized gains and losses as a convenience to their clients. Ultimately, however, the taxpayer is responsible for reporting the correct basis on their tax return when a stock is sold, so even if your broker provides basis information for stocks or funds that you’ve sold, you should verify the information’s accuracy with your own records.
The following is a discussion of commonly encountered basis adjustments where recordkeeping is essential:
- Reinvested cash dividends – Investors are frequently given the opportunity to reinvest their dividends rather than taking them in cash. By participating in these plans, investors are actually purchasing additional shares with their taxable dividends. Generally, the first shares acquired are considered to be the first ones sold. However, if certain conditions are met, investors may use an average cost basis for shares acquired in a dividend reinvestment plan after December 31, 2010. In either case, unless records are kept, an investor will be unable to prove how much he or she paid for shares or establish the amount of gain that is subject to tax (or the amount of loss that can be deducted) when shares are sold.
- Stock dividends – It is possible to receive both taxable and nontaxable stock dividends. Stock dividends that are taxable provide the investor with additional stock, with a basis equal to the taxable stock dividend. If the dividends are nontaxable, the number of shares that are owned increases, but the basis remains unchanged. If the investor can associate the dividends with a specific block of stock, then the basis of that block can be adjusted accordingly. If not, the adjustment will apply to the entire holdings in that particular stock.
- Return of capital – A return of capital is a nontaxable return of a portion of an investment. Thus, a return of capital will reduce the investor’s basis in a security. Suppose, for example, that an investor has 100 shares of XYZ Corporation at a cost of $1,000 ($10 per share), and the corporation distributes to him a $100 nontaxable return of capital. His basis in the stock will be reduced to $900 ($1,000 – $100) or $9.00 per share. If, over a period of time, the return of capital exceeds his basis in the investment, then the excess becomes taxable because he cannot have a negative basis.
- Stock splits – Stock splits can be confusing if they are not tracked as they occur. Let us assume that an investor owns 100 shares of XYZ Corporation, for which he paid $2,000 ($20 a share). Later, the corporation splits the stock, 2 for 1. The result is that he now owns 200 shares, but his basis in each has been reduced to $10 per share (200 shares times $10 equals $2,000 – what was paid for the original shares). This generally occurs when the “per share value of stocks” becomes too high for small investors to purchase 100 share blocks. Also, watch for reverse splits, which have the opposite effect.
- Stock spin-off – Occasionally, corporations will spin-off additional companies. The most classic such example is the break up of AT&T many years ago into regional phone companies, who themselves later split into additional companies or merged with others. Every time one of these types of transactions takes place, the corporation will provide documentation as to how to split the prior basis between the resulting companies. Tracking these events as they happen is very important, as it may be difficult to reconstruct the information several years down the road.
- Broker fees – Although broker fees are a deductible expense, they are generally already accounted for in most stock and bond transactions. The purchase price of a block of stock generally includes the broker fees, and the sales price reported to the IRS (gross proceeds of sale) is the net of the sales costs.
Depending upon the investment vehicle, tracking the basis of an investment can be quite complicated. If you have any questions, please contact this office.