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Subject: The Investment FAQ (part 15 of 20)

This article was archived around: 21 May 2006 04:23:42 GMT

All FAQs in Directory: investment-faq/general
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Archive-name: investment-faq/general/part15 Version: $Id: part15,v 1.61 2003/03/17 02:44:30 lott Exp lott $ Compiler: Christopher Lott
The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 15 of 20. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2003 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Survey of Stock Investment Strategies Last-Revised: 20 Jan 2000 Contributed-By: John Price (johnp at sherlockinvesting.com) This article offers a brief survey of several strategies that investors use to guide their stock purchases and sales. Before we start the survey, here's a golden rule of investing: Know why you are buying a particular stock -- donít wait until its price goes up or down to think about it. Many investors are not sure why they bought a stock in the first place, so when a dramatic fall in price happens, they're not sure what to do next. Here's an example. Let's say you bought Intel. When you know why you bought Intel you will have a stronger basis for knowing what to do when its price goes up, or down, or even stays the same. So if Intel starts to go down in price and you bought it as a momentum play, then you will probably want to sell as quickly as possible. But if you bought it as an undervalued stock, and if the fundamentals have not changed, then you might want to buy more." Of course, every investor and every stock presents a different reason for contacting your broker. But we have to start somewhere, so here is my analysis of the six main investment styles. Brother-in-law investor Your brother-in-law phones, or perhaps your stockbroker or the investment writer for the regional newspaper. He has the scoop on a great stock but you will have to act quickly. If you are likely to buy in this situation, then you are a "brother-in-law investor." Brother-in-law investors rely on the advice of other people to make their decisions. Technical investor Moving averages, candlestick patterns, Gann charts and resistance levels are the sort of things the technical investor deals with. Technical investors were once called chartists because their central activity was making and studying charts of stock prices. Nowadays this is usually done on a computer where advanced mathematics combines with grunt power to unlock past patterns and correlations. The hope is that they will carry into the future. Economist investor This type of investor bases his decisions on forecasts of economic parameters. A typical statement is "The dollar will strengthen over the next six months, unemployment will decrease, interest rates will climb -- a great time to get into bank stocks." Random walk investor This is the area of the academic investor and is part of what is called Modern Portfolio Theory. "I have no idea whether stock XYZ will go up or down, but it has a high beta. Since I donít mind the risk, Iíll buy it since I will, on the average, be compensated for this risk." At the core of this strategy is the Efficient Market Hypothesis EMH. There are a number of versions of it but they all end up at the same point: the current price of a stock is what you should buy, or sell, it for. This is the fair price and no amount of analysis will enable you to do any better, says the EMH. With the Efficient Market Hypothesis, stock prices are assumed to follow paths that can be described by tosses of a coin. Scuttlebutt investor This approach to investing was pioneered by Philip Fisher and consists of piecing together information on companies obtained informally through wide-ranging conversations, interviews, press-reports and, simply, gossip. In his book Common Stocks and Uncommon Profits, Fisher wrote: Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge. Fisher also suggests that useful information can be obtained from vendors, customers, research scientists and executives of trade associations. Value Investor In the fourth edition of the investment classic _Security Analysis_, the authors Benjamin Graham, David Dodd, and Sydney Cottle speak of the "attempts to value a stock independently of its current market price". This independent value has many names such as `intrinsic value,í `investment value,í `reasonable value,í `fair value,í and `appraised value.í They go on to say: A general definition of intrinsic value would be "that value which is justified by the facts, e.g., assets, earnings, dividends, [and] definite prospects, including the factor of management." The primary objective in using the adjective "intrinsic" is to emphasize the distinction between value and current market price, but not to invest this "value" with an aura of permanence. Value investing is the name given to the method of deciding on individual investments on the basis of their intrinsic value as contrasted with their market price. This, however, is not the standard definition. Most authors refer to value investing as the process of searching for stocks with attributes such as a low ratio of price to book value or a low price-earnings ratio. In contrast, stocks with high price to book value or a high price-earnings ratio are called growth stocks. Investors searching for stocks from within this universe of stocks are called growth investors. These two approaches are usually seen to be in opposition. Not so, declared Warren Buffett. In the 1992 Annual Report of Berkshire Hathaway he wrote, "the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." Conscious Investor This type of investor overlaps the six types just mentioned. Increasingly investors are respecting their own beliefs and values when making investment decisions. For many, quarterly earnings are no longer enough. For example, so many people are investing in socially responsible mutual funds that the total investment is now over one trillion dollars. Many others are following their own paths to clarify their investment values and act on them. The process of bringing as much honesty as possible into investment decisions we call conscious investing. Most people invest for different reasons at different times. Also they donít fall neatly into a single category. In 1969 Buffett described himself as 85 percent Benjamin Graham [Value] and 15 percent Fisher [Scuttlebutt]. Whatever approach, or approaches, you take, the most important thing is know why you bought a particular stock. If you bought a stock on the recommendation of your neighbor, be happy about it and recognize that this is why you bought it. Then you will be more likely to avoid the "investor imperative," namely the following behavior: If your stock rises, claim it as your ability; if it falls, pass on the blame. Do all that you can to avoid going down this path. Write down why you bought a stock. Tell your spouse your reasons. Tape them on your bathroom mirror. Above all, if you want to be a successful investor, donít kid yourself. For more insights from John Price, visit his site: http://www.sherlockinvesting.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Value and Growth Last-Revised: 23 Oct 1997 Contributed-By: Chris Lott ( contact me ) Investors will frequently read about value stocks (or value strategies) as well as growth stocks (and growth strategies). These terms describe reasons why people believe certain stocks will increase in value. This article gives a brief summary. The value strategy attempts to find shares of companies that represent good value (i.e., value stocks). In other words, their stock prices are lower than comparable companies, perhaps because the shares are out of favor with Wall Street. Eventually, they believe, the market will recognize the true value of the stock and run up the price. People who believe in this strategy are sometimes called fundamentalists because they focus on the fundamentals of the company. The grand champion of this strategy is (was) Benjamin Graham, author of two classic investment books, Security Analysis and The Intelligent Investor. Measures of value may be a company's book value, earnings, revenue, brand recognition, etc, etc. The growth strategy attempts to find shares of companies that are growing and will continue to grow rapidly (i.e., growth stocks). In other words, their earnings are increasing nicely and the stock price is increasing along with those earnings. People who believe in this strategy are sometimes called momentum investors. They are sometimes criticized for paying high prices for growth and ignoring fundamentals. Measures of growth usually focus on the earnings growth. With just a little bit of looking, it's easy to find mutual funds that take one, the other, or a combined strategy. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Backup Withholding Last-Revised: 20 Mar 1997 Contributed-By: John Schott (jschott at voicenet.com) Once the IRS declares you a "Bad Boy" (for having underpaid or been negligent on your tax filings in other ways) they stick you with "Backup Withholding." What this means, essentially, is that any firm that deals with your money in taxable tranactions is required to withhold (and submit to IRS) 31% of the proceeds of ANY transaction (on the assumption that the entire amount is a taxable gain). Then, next year when you file, they have all this money of yours, and you might be able to get it back if it is in excess of your actual tax liability once they have themselves determined it is indeed excess. So if you trade often, 31% disappears each time and soon all of your capital is held by the IRS. I think that your time in the "penalty box" lasts for 5 years (I'm not sure) if you remain faultlessly clean and petition to have it lifted. In short - this is not something you want to get into. By the way, there is a substantial penalty if you lie to the broker about whether you are subject to this treatment. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Capital Gains Cost Basis Last-Revised: 7 Jan 2000 Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact me ) This article discusses how to determine the cost basis of a security according to the rules of the US tax code. The most common need for the cost basis of a security like stock is to report the proper gain or loss when that security is sold. This article sketches the issues for the simple case (you bought a security) and a couple less simple cases (you are given or inherit a security). Of course you might have not just one share but instead many hundreds; the word "security" is used here for simplicity. You bought the security The cost basis is simply the money you paid when you bought the security, including any commissions that you paid to acquire that security. For example, if you bought 10 shares of IBM at 100 and paid $29.95 in commission to do so, your cost basis would be 1029.95. This example lists just a single purchase of a security. If you accumulated stock over the course of many purchases, the total cost basis is still just the cost of all the purchases including commissions. The situation gets a bit more complex if you sell only a portion of an investment; see the FAQ article about computing capital gains for more information about this. You were given the security To oversimplify the issue, if the shares are given away at a gain, the donor's cost basis and acquisition date are used. If the shares are given away at a loss, the fair market value as of the date of gift must be used to calculate a subsequent sale at a loss, while the donor's cost basis must be used to calculate a subsequent sale at a gain. In the case of a gift at a loss, which is later sold at a loss, the date of the gift is used as the "acquisition date" of that stock. All of this means that an individual can transfer a gain but not a loss to another individual. Read on for all the details. The date when the gift is made is important. To figure the cost basis, the fair market value (FMV) of the gift on the gift date must be determined. A local library's microfilm archive might be the best resource to find the value of shares on a particular date. But be cautious about stock splits and other stock dividends! It's wise to consult the S&P stock guide, the Value Line Investment Survey, or the company that issued the shares for a history of the stock price, stock splits and dividends, etc. In the happiest and simplest case, the donor bought shares for a pittance, and donated them to some lucky individual, maybe you, after the shares had appreciated dramatically. That individual immediately sold the shares. The fair market value (FMV) of the shares on the gift date far exceeded the original cost basis, so the recipient's cost basis is the same as the donor's cost basis (possibly small, but definitely NOT zero). For example, the donor's cost basis is $20, and the FMV on the date of the gift is $100. The cost basis that the recipient must use is $20. On the other hand if the shares were sold for only $5, the same cost basis is used, and the loss is $15. In both cases, the acquisition date that must be reported is the same as the donor's acquisition date. The other possibility, of course, is that the share's FMV on the gift date was less than the original cost basis thanks to some decline in value. In this case, the gift assumes a dual cost basis that is not determined until the shares are sold. The donor's cost basis must be used to determine the gain if the shares are sold at a gain. The FMV on the date of the gift must be used if the shares are sold at a loss. For example, the donor's cost basis is $20, and the FMV on the date of the gift is $10, thus establishing a dual cost basis. Here are three possibilities. * Case 1: If the shares are subsequently sold for $25, this is a gain with respect to the donor's original cost basis and the FMV, so the recipient consequently reports a gain of $5, namely $25 (sales price) less 20 (donor's cost basis). * Case 2: If the shares are sold for $8, this is a loss with respect to the donor's original cost basis and the FMV, so the recipient consequently reports a loss of $2, namely $8 (sales price) less $10 (FMV on gift date). * Case 3: Here's where it gets complicated. If the shares are sold for $15, representing a loss with respect to the donor's cost basis but a gain with respect to the FMV on the gift date, what cost basis should the recipient use? * If the donor's cost basis of $20 is used, this would produce a loss for the recipient. However, the $20 can be used only when the recipient has a gain, so that's out. * If the FMV of $10 is used, this would produce a gain for the recipient. However, the $10 can be used only when the recipient has a loss, so that's out too. Result: The recipient has neither a gain or loss. The acquisition date that must be reported depends on the cost basis, and is pretty straightforward. If the donor's cost basis is used, use the donor's acquisition date, and if the FMV on the date of the gift is used, use the date of the gift. The IRS is light on advice as to how to report a transaction where the stock was given at a loss, and the sale produces neither gain nor loss. If you report the net sales price and then show the cost basis equal to the sales price, you end up with no gain. You can choose to use either the date of gift or original date as your acquisition date, since no gain or loss makes it a pretty much "don't care" condition. You inherit a security The cost basis is simply the value of the security on the date of the person's death who bequeathed that security to you. (The accountant lingo for this is "when the stock was inherited, its cost basis was stepped up to fair market value on date of death".) The easiest way to get this is probably to look in a library's archive (probably on microfiche or CD-ROM) of the Wall Street Journal or the New York Times. Don't forget about stock splits while doing the research. In rare cases, the executor will choose to use an "alternate valuation date" instead of date of death. The alternate valuation date, always 6 months after death, can be chosen only when it will reduce the estate tax, and if chosen, must be used for all property of the estate. An executor who makes this election should notify the heirs of the value used. Note that when figuring capital gains taxes, inherited property is always long term, per se. In fact if you glance at Pub 550 it asks you to not use an acquisition date for inherited property but to write "INH" to indicate it is inherited property. Be careful of reinvested dividends! If a stock paid dividends and the dividends were reinvested, computation of a fair cost basis requires a bit of work. All reinvested dividends need to be added to the cost basis, otherwise the cost basis will be much too low and the person who sells the security will pay too much tax. If the dividend payment and reinvestment records are not available, you need to reconstruct them. Find out from old Wall Street Journals or New York Times financial sections how much the dividend was each year since the stock was acquired or inherited, and use the number of shares and price per share on the dividend pay date. You might use a spreadsheet to show number of shares each year, amount of dividend, price at time of reinvestment, etc. This requires a good deal of researching the dividend amounts and the share price. If computing the cost basis of some security looks hopeless, here's an alternative to consider: donate some or all the shares to charity. If you normally make donations to your church, alumni association, or other charity, it is quite easy to persuade them to accept stock instead of cash. By doing so, you never have to calculate gains nor list the sale as income on your tax return. Moreover, if the stock was held more than a year (long-term gain), you get to itemize the charitable deduction at fair market value on the date of gift. Note that stock gifted to charity and held short term can be deducted at the lower of cost basis or fair market value. This implies that stock bought with reinvested dividends within a year of the gift would be limited to the lower of fair market value or cost basis. For the last word on the cost basis issue, see IRS Publication 551, "Basis of Assets." --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Capital Gains Computation Last-Revised: 4 Aug 1998 Contributed-By: John Schott (jschott at voicenet.com), Art Kamlet (artkamlet at aol.com), Chris Lott ( contact me ), Rich Carreiro (rlcarr at animato.arlington.ma.us) Gains made on equities (i.e., stocks or mutual funds) are subject to capital gains taxes. In the simplest case, you bought a lot of shares (either stocks or mutual funds) at some date, made no further investments (took your dividends in cash), and finally sold the shares at some later date. Your gain is simply the difference between your net cost and net income, and you report that as a capital gain. This article focuses on computing the amount of the gain (but not the amount of tax you'll have to pay, see the article on capital gains tax rates elsewhere in the FAQ for that). Note that this article discusses only realized capital gains. Tax is only due on a realized capital gain, never (at least not as of this writing) on an unrealized capital gain. A realized capital gain is money in your pocket. If you bought shares at 10 and sold at 20, you realized a capital gain of $10 per share, and of course Uncle Sam (and just about every other tax authority out there) wants a piece of the action. An unrealized capital gain is a gain that you have on paper; in other words, you bought a stock at 10, still hold the shares, and on some date it's trading at 20. You have an unrealized capital gain as of that date of $10 per share, and because it's unrealized, there are no tax implications. The first part of computing capital gains and gains taxes is determining the cost basis of the securities that you sold. For more information on that, see the FAQ article on computing cost basis . That article discusses how to compute the cost basis if you inherit or are given some stock or other equities. Computing gains is simple for a sale of a single share, or a sale of a single lot of shares. The situation becomes more complex if you acquired several lots of shares at different prices. It's not so bad for stocks, because when you sell shares of stock, you always, always, always sell specific shares. But when you sell shares in a mutual fund, things are not as simple. We'll cover these two cases next. * Selling shares of stock. For example, say you hold 200 shares of IBM, half of which you bought at $40 and half at $50 (I should be so lucky). What price should you use if you sell 100 shares? In this simple example, it's your choice: either $40 or $50. But, to be legal, you must specify to your broker precisely which lot you are selling before you give the sell order. IRS Pub 550 clearly says that adequate specific identification of shares has been made if you tell the broker at time of sale what shares are being sold and if the broker so notes it on the confirmation slip. Many brokers (especially as they now have years of computer records) are able to mark that on your confirmation slip automatically. But another way is to tell your broker and then get him to sign a confirmation letter attesting to that fact. If you don't do this, the IRS, in an audit, may reverse your decisions. Note that the broker is under no obligation to accept a specific shares order, but I personally would take my business to another broker if I ran into that. In any case, the key element in identifying specific shares to be sold is that you've got to convince the IRS that you made your choice of what shares to sell prior to the trade and convince the IRS that you informed the broker of that choice (also prior to the trade). If you don't tell the broker, and get no information on the confirmation slip, the specific shares you sell are the oldest (sometimes called first-in first-out or FIFO). * Selling shares of a mutual fund. Mutual fund investors have to choose one of four possible methods of computing their basis for sold shares. These are as follows. 1. Specific shares -- the investor decides which specific shares are to be sold. 2. First-in-first-out (FIFO) -- the oldest shares are sold first (this is actually a kind of specific shares). 3. Average cost, single category -- the basis of a share is the average basis of all shares. 4. Average cost, double category (may now be triple category, given the new capital gains law) -- shares are segregated by holding period, the basis of a share in a given category is the average basis of all shares in that category. Investors may switch between (1) or (2) as they like, but once (3) or (4) is chosen for a security, the investor must stick with that method until he has entirely liquidated his position in the security or receives IRS permission to change methods. The following discussion details the average cost, single category method (3), which is probably the most commonly used method. The description that "the basis of a share is the average basis of all shares" pretty much says it all. Despite this, the calculation often confuses people, especially when additional purchases are made subsequent to sales, and it can be laborious to keep track of everything. Key points to remember are the following. * Reinvestment of distributions are treated exactly like (and in fact are) purchases. * Every time a sale is made, the basis of every remaining share becomes the average cost used in the sale calculation. A share has no "memory" of what its previous basis values were. * For purposes of computing holding period only, you are deemed to be selling the oldest shares first. You have no choice in the matter. Various software packages such as Captool, by Captools Inc (formerly Techserve) can do the computation for you. If I were doing it manually (or using a spreadsheet) I'd probably do something like the following. 1. Divide a piece of paper into six columns. Label them "Date", "Number of shares", "Cost", "Total Shares", "Total Cost" and "Average Cost". 2. Fill in the first three columns for all your purchases up to the point of your first sale. 3. Now fill in the "Total Shares" column. Obviously, for the first entry this will be equal to the number of shares bought. For subsequent entries, it will be equal to the "Total Shares" value of the previous entry plus the "Number of Shares" value for the current entry. 4. Fill in the "Total Cost" column the same way. 5. Fill in the "Average Cost" value for the final entry by dividing that entry's "Total Cost" value by its "Total Shares" value. You could do this for every entry (and that would be the easier thing to do in a spreadsheet) but only the average cost as it existed right before a sale matters, and if you're doing it manually why waste the time computing and writing down numbers you won't need? 6. Now put in an entry for your first sale. * Put down the date. * Put the quantity of shares sold in the "Number of Shares" entry as a *negative* number (you are selling them, after all). * Multiply "Number of Shares" by the average cost you got in step (5) and enter that in the "Cost" column. This will be negative -- as well it should -- since a sale reduces your total basis by the basis of the shares that are sold. * Fill in "Total Shares" for this entry like you did in step (3). Since "Number of Shares" for this entry is negative, "Total Shares" will decrease as it should. * Fill in "Total Cost" for this entry like you did in step (4). Since "Cost" for this entry is negative, "Total Cost" will decrease as it should. * Note that your gain (or loss) on the sale is the sum of your sales proceeds and the "Cost" value (which is a negative number) of the sale entry. 7. If your next transaction is a sale, do it just like (6). If your next transaction is a purchase: * Put down the date. * Put down the shares bought in the "Number of Shares" column. * Put down the cost in the "Cost" column. * Fill in "Total Shares" as in step (3). * Fill in "Total Cost" as in step (4). * If desired, fill in average cost column. You only really have to do this for a purchase entry that immediately preceeds a sale entry. 8. Keep the sheet up to date with all purchases and sales as you make them. Note that this procedure only tells you the overall gain or loss on a sale. You still have to determine the holding period for the shares sold, and if multiple holding periods are involved, apportion the gain or loss into each holding period. As previously stated, you must consider the oldest remaining shares to be the ones sold for this purpose. So if you sell N shares, go back to your purchase records and mark off (physically or mentally) the oldest remaining N shares (which may well be from different purchases) and see what the holding periods are. Here's an example for all of this: * On 02/01/97 buy 100sh for $1000. * On 08/01/97 buy 75sh for $1000. * On 12/23/97 reinvest $600 of distributions getting 40sh. * On 12/01/98 sell 200sh for $4000. * On 12/24/98 reinvest $300 of distributions getting 14sh * On 06/15/99 buy 100sh for $2000 * On 10/31/99 sell 50sh for $900 Date Nr Shares Cost Total Shares Total Cost AvgCost 02/01/97 100 $1000.00 100 $1000.00 08/08/97 75 $1000.00 175 $2000.00 12/23/97 40 $ 600.00 215 $2600.00 $12.0930 12/01/98 (200) ($2418.60) 15 $ 181.40 12/24/98 14 $ 300.00 29 $ 481.40 06/15/99 100 $2000.00 129 $2481.40 $19.2357 10/31/99 (50) ($961.79) 79 $1519.61 Since the basis of the shares sold on 12/01/98 was $2418.60 while the proceeds of that sale were $4000, there was a $1581.40 gain on the sale. The shares that were sold were the 100 shares purchased 02/01/97, the 75 shares purchased 08/08/97, and 25 of the forty shares purchased 12/23/97. The 100 shares purchased 02/01/97 have a holding period of over 12 months, the 75 shares purchased 08/08/97 also have a holding period of over 12 months, and the 25 shares sold out of the block of 40 purchased 12/23/97 have a holding period of less than 12 months. Enter each piece in the appropriate part of Schedule D, prorating the $2418.60 basis and the $4000 proceeds across the pieces based on the number of shares in each piece. Now, since the basis of the shares sold on 10/31/99 was $961.79 while the proceeds were $900, there was a $61.79 loss on that sale. The shares that were sold were the remaining 15 shares in the block of forty purchased 12/23/97, the 14 shares purchased 12/24/98, and 21 shares from the block of 100 purchased 6/15/99. The 15 shares purchased 12/23/97 have a holding period over 12 months, while both the 14 shares purchased 12/24/98 and the 21 shares purchased 06/15/99 have holding periods under 12 months. Again, enter each piece in the appropriate parts of Schedule D, prorating the $961.79 basis and the $900 proceeds. Finally, there's a reporting shortcut. If you have multiple purchase blocks in the same holding period category, you can combine them into a single entry. Just write "various" for the acquisition date and combine the basis and proceeds of the blocks to get the basis and proceeds of the single entry. For example, for the 10/31/99 sale, on the short-term part of Schedule D I would combine the 14 12/24/98 shares and the 21 6/15/99 shares into a single entry, reporting 35 shares, acquisition date of "various", sell date of 10/31/99, basis of $673.25, proceeds of $630.00, and a loss of $43.25. And now you see why I use a piece of software to track all this and generate reports for me :-). Remember that the averaging method for computing cost basis applies only to shares of mutual funds and does not apply to conventional stock sales. A cost basis includes brokerage and all other costs specifically attributable to holding the security. Be sure to correct your per-share values for stock splits (see the article elsewhere in the FAQ for more information about splits) and dividends, as well as any participation in a DRIP. Ok, hopefully by now you have computed the total gain on your equity sales. Now you have to figure out how much tax you owe. Please see the article in the FAQ on capital gains tax rates for more help. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Capital Gains Tax Rates Last-Revised: 10 Jan 2001 Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us) While reading misc.invest.*, you may have seen people talking about "long-term gains" or "short-term losses." Despite what it sounds like, they are not talking about investment strategies, but rather a potentially important part of the United States tax code. All this matters because the IRS taxes short- and long-term gains differently. The "holding period" is the amount of time you held some security before you sold it. For reasons explained later, the IRS cares about how long you have held capital assets that you have sold. The holding period is measured in months. The nominal start of the holding period clock is the day after the trade date, not the settlement date. (I say nominal because there are various IRS rules that will change the holding period in certain circumstances.) For example, if your trade date is March 18, then you start counting the holding period on March 19. On April 19 your holding period is one month. On May 19 your holding period is two months, and so on. With holding period defined, we can say that a short-term gain or short-term loss is a gain or loss on a capital asset that had a holding period of 12 months or less, and that a long-term gain or long-term loss is a gain or loss on a capital asset that had a holding period of more than 12 months. Note that a short-sale is considered short-term regardless of how long the position is held open. This actually makes a kind of sense, since the only time you actually held the stock was between when you bought the stock to cover the position and when you actually delivered that stock to actually close the position out. This length of time is somewhere from minutes to a few days. Net capital gains and losses are fully part of adjusted gross income (AGI), with the exception that if your net capital loss exceeds $3,000, you can only take $3,000 of the loss in a tax year and must carry the remainder forward. If you die with carried-over losses, they are lost. Short-term and long-term loss carryovers retain their short or long-term character when they are carried over. Discussions from this point on talk about the various tax rates on capital gains. It is important to note that these rates are only the nominal rates. Because capital gains are part of AGI, if your AGI is such that you are subject to phaseouts and floors on your itemized deductions, personal exemptions, and other deductions and credits, your actual marginal tax rate on the gains will exceed the nominal tax rate. Short-term gains are taxed as ordinary income. Therefore, the nominal tax rate will be whatever tax bracket you are in. Long-term gains are a somewhat more complicated. The majority of people will only have two rates to worry about -- 10% and 20%. Your long-term gains are taxed at 10% if you are in the 15% bracket overall and 20% if you are in any other bracket. The long-term gains are included when figuring out what bracket you're in. However, the 10%/20% rate doesn't apply to all long-term gains. Long-term gains on collectibles, some types of restricted stock, and certain other assets are instead subject to rate that is the lesser of your tax bracket or 28%. And certain kinds of real estate depreciation recapture are taxed no higher than 25%. I do note that for 1998 only, many average investors will see some so-called 28% gain. This will be from mutual fund capital gain distributions made in the 1st quarter of 1998 for gains realized by the fund in the closing months of 1997, when a different set of rules was in place. Your fund should provide explanations when you receive 1099-DIV forms in early 1999. Another complication in long-term taxation arrives January 1, 2001. As of that day (unless Congress changes things before than), lower rates come into effect for gains having a holding period of over 60 months (called the "ultra-long-term rate" here). The rates are 8% if you are in the 15% bracket, 18% otherwise. If the asset was acquired before 1/1/2001 it can never gain 8%/18% (i.e., ultra-long-term) status (with exceptions) no matter how long it is held. The exception is that you can mark the asset to market at its fair market value on 1/1/2001. You will have to declare as income and pay tax on any unrealized gain (and presumably get to deduct any unrealized loss) on the asset. The holding period clock will also reset. (This is the same as selling and repurchasing the asset without actually doing so. It is currently unclear if wash sale rules will apply to loss property marked to market). There is yet another twist to this exception -- if you are in the 15% bracket, the 8% rate is available to you as of 1/1/01, even if you did not acquire the asset before 1/1/01. In any case, I strongly advise researching the issue and talking to a tax professional before doing something that is subject to this rule. Here's a summary table: Tax Bracket S-T Rate L-T Rate U-L-T Rate 15% 15% 10% 8% 28% 28% 20% 18% 31% 31% 20% 18% 36% 36% 20% 18% 39.6% 39.6% 20% 18% As you can see, the ordinary income and short-term rate is over 100% higher (39.6% vs. 18%) than the ultra-long-term rate and close to 100% higher than the long-term rate. While you should never let the income tax "tail" wag the prudent investing "dog," the ultra/long/short term distinction is something to keep in mind if you are considering selling at a gain and are getting close to one of the holding period boundaries, especially if you are close to qualifying for long-term treatment. Now what happens if you have both short-term capital gains and losses, as well as long-term gains and losses? Do short-term losses have to offset short-term gains? Do long-term losses have to offset long-term gains? Well, the rules for computing your net gain or loss are as follows. 1. You combine short-term loss and short-term gain to arrive at net short-term gain (loss). This happens on Sched D, Part I. 2. You combine long-term loss and long-term gain to arrive at net long-term gain (loss). This happens on Sched D, Part II. 3. You combine net short-term gain (loss) and net long-term gain (loss) to arrive at net gain (loss). This happens on Sched D, Part III. * If you have both a short-term loss and a long-term loss, your net loss will have both short-term and long-term components. This matters if you have a loss carryover (see below). * If you have both a short-term gain and a long-term gain, your net gain will have both short-term and long-term components. This matters because only the long-term piece gets the special capital gains tax rate treatment. * If you have a gain in one category and a loss in another, but have a gain overall, that overall gain will be the same category as the category that had the gain. If you have a loss overall, that overall loss will be the same category as the category that had the loss. 4. If you have a net loss and it is less than $3,000 ($1,500 if married filing separately) you get to take the whole loss against your other income. If the loss is more than $3,000, you only get to take $3,000 of it against other income and must carry the rest forward to next year. When taking the $3,000 loss, you must take it first from the ST portion (if any) of your loss. The Capital Loss Carryover Worksheet in the Sched D instructions takes you through this. 5. If you have a net gain, the smaller of the net gain or the net long-term gain will get the special tax rate. This happens on Sched D, Part IV. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Cashless Option Exercise Last-Revised: 12 June 2000 Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact me ) This article discusses the tax treatment of an employee's income that derives from stock options, specifically the case in which an employee exercises non-qualified stock options without putting any money down. First, a digression. What is a non-qualified option? A non-qualified stock option is the most popular form of stock option given to employees. Basically, an employee who exercises a non-qualified option to buy stock has to report taxable income at the time of the purchase, and that income is taxed as regular income (not as a capital gain). In contrast, an incentive stock option (ISO) dodges these tax bullets, but is more complicated because employees who receive ISOs have to worry about alternative minimum tax (AMT). Unfortunately some companies are sloppy about naming, and use the term ISO for what are really non-qualified stock options, so be cautious. Next, what is a cashless exercise? Basically, this is a way for an employee to benefit from his or her stock option without needing to come up with the money to purchase the shares. Any employee stock option is basically a call option with a very long expiration; hopefully it's also deep in the money (also see the FAQ article on the basics of stock options ). When a call option is exercised, the person who exercises it has to pay to buy the shares. If, however, the person is primarily interested in selling the shares again immediately, then a cashless option becomes interesting. The company essentially lends the person the money needed for the option exercise for the fraction of a second that the person owns the shares. In a typical cashless exercise of non-qualified stock options (you can tell it is non-qualified because the W-2 form suddenly has a huge amount added to it for stock option exercise), here is what happens. Let's use E as the Option Exercise Price and FMV as the fair market value of the shares. The employee needs to pay E as part of the option exercise. But this is a cashless exercise, so the company (or, more likely, a broker acting as the company's agent) lends the employee that amount (E) for a few moments. The stock is immediately sold, for FMV. The broker takes back the amount, E, loaned to the employee for the exercise, and pays out the difference, FMV-E. The broker will almost certainly also charge a commission. Ok, now for those fortunate people who are able to do a cashless stock option exercise, and choose to do so, how do they report the transaction to the IRS? The company imputes income to the employee of the difference between fair market value and exercise price, FMV-E. That amount is added to the employee's W-2 form, and hopefully shows up in Box 14 with a cryptic note such as STKOPT or whatever. The amount FMV-E is the imputed income. Again, you will notice FMV-E is not only what the broker paid out, it is also the imputed income amount that shows up in the W-2 form. The Schedule D sales amount reported by the broker is FMV minus any commission. The employee's cost basis is the FMV. So the FMV is the sales price, and the Schedule D for this transaction will show zero (if no commission was charged) or a small loss (due to the commission). In certain situations, FMV might differ slightly from the price at which the shares were sold, depending on how the company does it, and if so, the company should report the FMV to the employee. Then the Schedule D must be completed appropriately to show the short-term gain or loss (the difference between the sales price and FMV). For extensive notes on stock and option compensation, visit the Fairmark site with articles by Kaye Thomas: http://www.fairmark.com/execcomp/index.htm Julia K. O'Neill offers an extensive discussion of the differences between incentive stock options and non-qualified options: http://www.flemingoneill.com/stockopt.html --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Deductions for Investors Last-Revised: 24 Oct 1997 Contributed-By: Art Kamlet (artkamlet at aol.com), David Ray This article offers a brief overview of the deductions that investors can claim when filing US tax returns. The most significant one is losses. An investor may deduct up to US$3,000 in net capital losses each year using the Form 1040 Schedule D. Additional losses in a calendar year can be carried forward to the following year. Note the key word in the first sentence: net capital losses. For example, if you realized $5,000 in capital gains and $9,000 in capital losses during a tax year, you would have a net capital loss for that year of $4,000. You could deduct $3,000 for that year, and carry forward $1,000 of net loss to the following year's tax return. Another example: if you realized a loss of 4,000 in one stock and a net gain of 4,000 in a second stock, you could not deduct anything because the net loss was zero. What about margin interest? If you borrow money to purchase securities (not tax-exempt instruments), and if you itemize deductions on Schedule A, you can itemize as investment interest on Schedule A (Interest, not Misc. deductions) the investment interest you actually paid, but only to the extent you had that much investment income. Investment interest that you cannot claim because you didn't have enough investment income can be carried forward to the next year. Investment income includes investment interest, dividends, and short-term capital gains. You can elect to include mid- and long-term capital gains, but if you do, you cannot choose to elect tax-favored treatment of those gains. --------------------Check http://invest-faq.com/ for updates------------------ aSubject: Tax Code - Estate and Gift Tax Last-Revised: 6 Jan 2003 Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Art Kamlet (artkamlet at aol.com), John Fisher (TaxService at aol.com), Chris Lott ( contact me ) This article offers an overview of the estate and gift taxes imposed in the United States. The main issue is the amount of money a person can "gift" (used as a verb in this context) to another person without tax consequences, as well as the tax consequences when that amount is exceeded. The handling of estates is relevant and discussed with gift taxes because transfers while a person is living (i.e., gifts) can influence estate taxes. Here's a brief summary. An estate of less than US$1,000,000 will not be taxed in 2003 (although it depends on prior gifts, read on). A gift recipient never has anything to worry about, no matter the size, because gifts are not taxable income. A gift giver who gives less than $11,000 to any one individual in one year also has nothing to worry about. If a person gives more than $11,000 to an individual in one year, then the regulations discussed in the rest of this article must be followed carefully. Finally, note that gifts are never deductable from a gift giver's gross income. A fundamental concept to understand here is the unified credit . Roughly speaking, this is the amount of wealth that the IRS (well, really the US Congress) allows a person to transfer without incurring various tax obligations. As of this writing, the unified credit amount for tax year 2003 is $1,000,000. But given the annual gift tax exclusion amount of $11,000 (newly increased in 2002 from 10,000 in prior years), the total amount that a person can effectively transfer to another individual without triggering taxes is much larger. The term "unified credit" is used because the credit is the "unified gift/estate tax credit". This is a single, combined credit amount that is applied against both gift and estate tax. A person can gift fairly large amounts annually without affecting the unified credit. Basically, any US taxpayer can gift up to $11,000 to a single person in a tax year and there are no tax consequences: the gift giver's lifetime unified credit is not affected, and the gift recipient pays no tax. In fact, a person can make $11,000 gifts to as many different people in a year as she or he likes with no tax consequences. (See below; this number is indexed to inflation and will change over time.) Spouses can give each other gifts of any amount without gift tax filings. Finally, a husband and wife can gift anyone $22,000 without gift tax consequences, but unless the husband gives 11,000 and the wife gives 11,000 (e.g., they both write a check), they should file a Form 709a with the IRS and elect to use gift splitting. What is gift splitting? Gift splitting means a husband and wife can elect to treat a gift given by one of them as if half were given by each of them. The implications are simple: If one spouse gives $22,000 to someone during the year, and gift splitting is not elected, the IRS can treat that as a 22,000 gift by just the one spouse, even if the funds are drawn from a joint account. The IRS Form 709a can be filed for notifying the IRS that gift splitting is elected. (The instructions for the form are on the form itself.) This is a bit silly in many cases, since in community property states, community property is automatically considered split equally between each spouse, but that requires the IRS to somehow know it came from community property funds and not from non-community funds. So they require you to prove it, basically. If a donor gives away more than $11,000 to a person (not a charity) in a tax year, then the donor may owe gift tax, depending on the donor's history of giving. After making a large gift, the donor is responsible for filing a Form 709 declaring that gift and keeping a running, lifetime total of the lifetime exclusion used. As long as the exclusion is below the maximum, no gift tax is due. Once the exclusion reaches the maximum, the donor calculates the tax due with Form 709 and attaches a check (payable to the United States Treasury). So in a nutshell, computation of gift tax is quite easy: just fill out the 709. If there is some remaining lifetime gift tax exclusion remaining, then there is no tax due. If there is no exclusion remaining, there is tax due. Note that there is no way to pay gift tax and somehow "preserve" some amount of lifetime exclusion; the system simply does not work that way. Now we'll discuss the lifetime exclusion. Basically, the first $1 million of transfers in life and death are exempt from estate and gift tax as of 2002 (and remains that way in 2003). However, it is not handled in quite in the way that most people think. Most people (for example) think that when someone who made no taxable transfers during life dies, you total up the estate, subtract off any deductions, and then subtract $1,000,000 and compute the tax on whatever (if anything) is left. The way it actually works is that you subtract off any deductions, compute the tax on that amount, and then apply against the tax the unified credit of about $300,000 (this number needs to be checked). Of course the result is identical for most estates; the first $1 mil of the estate is not taxed. But look what happens to the first dollar past the limit. If the tax really was done the first way, the taxable estate would be $1, and you'd be starting at the bottom of the estate tax bracket structure. But what actually happens is that you compute the tax on an estate of $1,000,001, which leaves you in the middle of the bracket structure, and then subtract off the credit. So your marginal rate is much higher under the way things actual work than it is under the "naive" way. A gift (used as a noun) in this article means a gift of present value . A gift of present value is an unrestricted gift the receiver can use immediately (if an adult, or immediately upon becoming an adult). However, if a trust is set up for a child and the trust is payable to the child only on the child's 25th birthday provided the child has graduated from college and has no felony convictions, that gift is considered restricted (it's not a gift of present value), so a 709 would have to be filed starting at the first gift dollar. Note that if securities or other non-cash instrument is given, the fair market value of the securities on the gift date are used to determine whether the gift tax rules apply. Ok, time for an example: If an individual makes a gift of present value of $41,000 in a year, the 30,000 above the 11k limit reduces the amount of estate excluded from estate tax to the current limit less the 30,000. Now another example: What happens if a wealthy married couple (we'll call them Smith) gifts $44,000 to a less wealthy married couple (let's call them Doe)? This is perfectly ok and has no tax consequences provided things are done properly. Let's examine some of the possibilities. If a single check is drawn on Mr. Smith's account and deposited into Mrs. Doe's account, the very conservative amongst the tax folk will point out that the gift was from Mr. Smith and not Mr. and Mrs. Smith and further, even if the check was to both Doe's, it was deposited into only one of the Doe's accounts, so it could be a gift of 44,000 from one person to another! Since the gift splitting rule is out there, the moderately conservative tax experts would have separate checks written to Mr. Doe and Mrs. Doe. The ultra conservative would have four checks written of 11k each (the combinations are left as an excercise for the reader :-). The use of four checks avoids the gift splitting election as well as the worry about whose account it is deposited in. (Since a spouse can gift unlimited amounts to the other spouse, it really should not matter.) Dramatic changes to the estate tax laws were made by the Economic Growth and Tax Relief Reconciliation Act of 2001. In fact, that act repealed the estate tax -- but with many caveats. The lifetime exclusion numbers for the next ten years are as follows: $1 million in 2003; 1.5 million in 2004 and '05, $2 million for 2006, '07, and '08, and finally $3.5 million in 2009. And in 2010, the estate tax is gone. But (don't you just love Congress), in 2011 the estate tax comes back with a lifetime exclusion of $1 million. This is how Congress balances its books. It's anyone's guess what will actually happen by 2011. Note that the gift tax was not repealed; the lifetime exclusion remains stuck at $1 million after 2011. And the annual gift tax exclusion amount is $11,000 in 2003; because this number is indexed to inflation, it is difficult to predict how this value will change in future years. To recap one important issue, the blessed repicients of a gift never pay any tax. Stated a bit differently, receipt of a gift is not a taxable event. Of course if someone gives you securities, and you immediately sell them, the sale is a taxable event. See the article elsewhere in the FAQ about calculating cost basis for help with computing the number used when reporting the sale to the IRS. For more information about estate issues, visit Robert Clofine's site: http://www.estateattorney.com/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Gifts of Stock Last-Revised: 20 Dec 1999 Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact me ) This article introduces some issues that crop up when making gifts of stock. Gift taxes are an orthogonal but closely related issue; see the article elsewhere in the FAQ for more details. Also see the FAQ article on determining the cost basis of securities for notes on computing the basis on shares that were received as a gift. Occasionally the question crops up from a person who has nice stock gains and would like to give some money to another person. Should the stockholder sell stock and give cash, or give stock directly? It's best to seek professional tax advice in this situation. If stock is given, and the recipient needs cash so sells the shares immediately, the recipient only keeps about 80% of the value after paying capital gains tax. I.e., the gift came with a big tax bill. On the other hand, if the stockholder sells some stock (perhaps to stay under the 10k annual exclusion), that pushes up that person's annual income. If the stockholder has a sufficiently high income, then the stock sale could push that person across various thresholds, one for which itemized deductions begin to be reduced, and the other where personal exemptions begin to be phased out. In addition, higher income could possibly trigger alternate minimum tax (AMT). --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2003 by Christopher Lott.