A capital gain is realized when an investor sells a security for more than its original cost. When you hear “buy low, sell high,” that’s the idea. If a security is sold for less than its cost, the investor has a capital loss.
A gain or loss is realized when the position is closed (long securities are sold, or short securities are repurchased). To find the gain or loss, investors compare their cost basis to their sales proceeds.
In other words, cost basis is what you paid in, and sales proceeds is what you got out.
To see how this works, walk through this example:
An investor purchases shares of ABC stock at $50 while paying a $2 per share commission. Several months later, the stock is sold for $70 while paying another $2 per share commission. What is the cost basis, sales proceeds, and capital gain or loss?
Can you figure it out?
Cost basis = $52
The cost basis equals the purchase price ($50) plus the commission ($2), which is the total amount paid to buy the shares.
Sales proceeds = $68
Sales proceeds equal the sale price ($70) minus the commission ($2), which is the total amount received from selling the shares.
The capital gain or loss = $16 capital gain
Subtract cost basis from sales proceeds: $68 - $52 = $16. A positive result is a capital gain; a negative result is a capital loss.
Capital gains can be long-term or short-term.
Long-term capital gains apply to securities held for more than one year. Technically, the investor must hold the investment for one year and one day to qualify for long-term status. Long-term capital gains are taxed similarly to qualified dividends: 0%, 15%, or 20%, depending on annual income.
Short-term capital gains apply to securities held for one year or less. They’re taxed at the investor’s ordinary income tax rate, which could be as high as 37% (similar to non-qualified dividends).
Capital gains are reported on Form 1099-B (the “B” stands for brokerage proceeds). Brokerage firms report customers’ capital gains and losses to the IRS each year. If the investor has more gains than losses (a net capital gain), they’ll owe taxes. A net capital loss can be used as a deduction.
Cost basis is used to calculate the capital gain or loss when a security is liquidated. In certain situations, the cost basis may be adjusted. Here are the two situations to know:
Death is an unfortunate part of life, but the IRS reduces tax burdens on inherited securities in two important ways:
When an investor dies, their assets pass to beneficiaries. The beneficiary’s new cost basis is the security’s value on the date of the original owner’s death. The beneficiary’s holding period is also treated as long-term, no matter how long the original owner held the investment.
Here’s an example:
An investor purchased 100 shares of ABC stock at $500 per share on January 10th, 2023. The investor died on June 10th, 2023 when ABC was at $1,000 per share. The investor’s daughter liquidated the inherited shares at $1,100 on July 1st, 2023.
Even though the shares were originally purchased at $500, the cost basis is “stepped up” to $1,000 on the date of death. That step-up can greatly reduce taxes.
The gain is also treated as long-term, even though the shares were held for only about six months.
Assuming the inheritor is in the 32% tax bracket, compare the tax liability:
With inheritance tax rules
Without inheritance tax rules
So, inheritance tax rules can significantly reduce tax liability. Instead of paying a 32% tax (the tax bracket that applies to short-term gains) on a $60,000 gain, the inheritor pays a 15% tax on a $10,000 gain. That’s a tax savings of $17,700.
This is a simplification for exam purposes; the actual rules when filing taxes are more complex.
Gifted securities don’t receive the same tax benefits as inherited securities.
Using the same facts as above (but treated as a gift):
An investor purchased 100 shares of ABC stock at $500 per share on January 10th, 2023. The investor gifted the shares to their daughter on June 10th, 2023, when ABC was $1,000 per share. The daughter liquidated the shares at $1,100 on July 1st, 2023.
In this case, the daughter keeps the original $500 cost basis and the short-term holding period.
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