Did you cash in some investments last year? Understanding the tax implications can be tricky. Here's help.
This is the fourth in a six-part series. In each article, you'll find advice from an experienced CPA on how to work the tax code to your advantage to trim your bill come April 17.
Did you sell some mutual fund shares on or before Dec. 31? Or perhaps you exchanged your home with its home office, for a bigger one.
How on earth do you calculate the taxes on these transactions? Here are the answers to these and other thorny tax questions.
To figure out how investment sales will be taxed, you need to know the asset's "basis." Generally, basis is simply the amount you paid for the investment or property. You have a gain if the amount you realize from a sale or trade is more than your basis. You have a loss if the amount is less than your basis.
Next, you have to figure out whether the asset is a "capital asset," meaning that the sale will be taxed as a capital gain or loss. What's a capital asset? Almost anything you own and use for personal purposes, pleasure, or investment, such as stocks held in your personal account, bonds, a house owned and used by you and your family, or jewelry. Exceptions include depreciable property used in your business. These are "noncapital assets," and a sale or trade of them results in an ordinary gain or loss.
The last step in calculating your tax bill is to figure out the property's holding period. If you owned it for more than a year, the sale will be taxed as a long-term capital gain or loss. If you held it for one year or less, it's a short-term capital gain or loss. To determine how long you held the investment, begin counting on the date after you acquired it. The last day of ownership, which is included in the holding period, is the day you disposed of the property.
Usually, a net long-term capital gain is taxed at 15 percent. A net short-term gain is taxed at ordinary income rates.
Those are the basics. But, of course, in the real world, complications always crop up, leaving you puzzled about your tax bill. Here are some common examples, with advice on how to determine your taxes.
Mutual funds. If you bought fund shares at different times or reinvested your dividends automatically, you can use your average share cost to represent the amount you paid, but if you do so, you must continue to use that method. Many brokers and mutual fund companies will provide this information, but sometimes you have to request it. (If you switch brokers make sure to get this information before you move.)
Alternatively, you can use the cost of the earliest shares you acquired or you can specifically identify which shares you want sold. If you want to take advantage of the specific identification method, make sure your broker sends you a written confirmation of your selling instructions. Your gain or loss will be long term if you owned the shares more than a year.
Remember, too, dividends that are reinvested increase basis. A physician invested $10,000 in a mutual fund for five years and then sold it for $15,000. He asked me if he had a $5,000 gain. It turned out he actually had a loss since he reinvested $6,000 of dividends. His basis was $16,000.
If your fund allows you to write checks against the value of your account, those checks are distributions and will affect your tax bill. To pay the checks you wrote, the fund redeemed some of your shares at their current value and reported these transactions to you. Using this information, you have to figure your gain or loss on each transaction, based on the amount you paid for the shares, and list it on Schedule D.
Corporate bonds. If you owned one for several years and the issuer decided to redeem it before maturity, the company paid you a premium for this privilege. This premium counts as a capital
gain, even though the interest that the bond generated is taxed at ordinary income rates. Since you owned the bond for more than a year, your long-term capital gains rate will be only 15 percent.