Capital gains & losses

A capital gain is realized when an investor sells a security at a higher price than its original cost. If you’ve heard anyone say, “buy low, sell high,” they’re talking about capital gains. Otherwise, selling a security below its cost is a capital loss. A gain or loss is realized upon a position being closed out (long securities sold or short securities repurchased). Investors compare their cost basis to sales proceeds to determine the overall gain or loss.

Cost basis represents the overall amount paid to buy the security, including commission (or other transaction fees). Sales proceeds represents the overall amount received to sell a security, minus commission. In basic terms, cost basis represents the overall amount paid for an investment, while sales proceeds represent the overall amount received for selling it. To better understand this concept, let’s work through an 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?

Capital gains can be long or short-term. Long-term capital gains are made on securities held for over a year. Technically, an investor must hold an investment for one year and a day to obtain long-term status. Long-term capital gains are taxed similarly to qualified dividends - 0%, 15%, or 20%, depending on their annual income level.

Short-term capital gains are made on securities held for one year or less and are taxed at the investor’s income tax bracket, which could be as high as 37% (similar to non-qualified dividends). Obviously, investors prefer long-term capital gains because they’re taxed at lower rates.

Capital gains are reported on form 1099-B (B stands for brokerage proceeds). Brokerage firms report their customers’ capital gains and losses to the IRS every year. If the investor has more gains than losses (net capital gain), they will owe taxes. A net capital loss can be used as a deduction.

Cost basis adjustments

As we just discussed, the cost basis helps determine the amount of capital gains or losses reported when a security is liquidated. In some circumstances, the cost basis may be adjusted. In particular, we’ll discuss these two situations:

• Inherited securities
• Gifted securities

Inherited securities

Death is an unfortunate aspect of life, but the IRS attempts to make the grieving process easier by reducing tax burdens on inherited securities. In particular, two tax-beneficial things occur:

• Cost basis is “stepped up”
• The holding period is automatically long-term

When an investor dies, their assets are passed to their beneficiaries. The new cost basis of the security reflects the value on the day of the original owner’s death. Also, the holding period for the inheritor is long-term, regardless of how long the original owner held the investment. To better understand this, let’s assume the following:

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.

Although the 100 shares were originally purchased at $500, the cost basis is “stepped up” to $1,000 when upon the original owner’s death. The step-up reduces taxation considerably. The investor locks in a taxable gain of $100 per share with the step-up ($1,000 cost basis vs. $1,100 sales proceeds). If the step-up didn’t occur, the inheritor would’ve reported a $600 taxable gain per share ($500 cost basis vs. $1,100 sales proceeds). Additionally, the gain is long-term, although the shares were only held for roughly six months.

Assuming the inheritor is in the 32% tax bracket, let’s look at the difference in tax liability:

With inheritance tax rules

• Cost basis = $1,000 per share
• Sales proceeds = $1,100 per share
• $100 taxable gain per share
• $100 gain x 100 shares = $10,000 overall gain
• $10,000 gain x 15% (long term gain rate) = $1,500 tax liability

Without inheritance tax rules

• Cost basis = $500 per share
• Sales proceeds = $1,100 per share
• $600 taxable gain per share
• $600 gain x 100 shares = $60,000 overall gain
• $60,000 gain x 32% (short term gain rate) = $19,200 tax liability

As you can see, the inheritance tax rules can significantly reduce tax liability. Instead of paying a 32% tax (tax bracket applies to short-term gains) on a $60,000 gain, the inheritor only pays a 15% tax on a $10,000 gain, resulting in tax savings of $17,700.

Gifted securities

This is a simplification for exam purposes; the actual rules when filing taxes are more complex.

Unlike inherited securities, gifted securities are not eligible for tax benefits. The original owner’s cost basis transfers directly to the person receiving the securities. Additionally, the holding period does not adjust. To better understand this, let’s use the same example from above (modified to be 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 retains the original cost basis of $500 and short-term holding period.

• Cost basis = $500 per share
• Sales proceeds = $1,100 per share
• $600 taxable gain per share
• $600 gain x 100 shares = $60,000 overall gain
• $60,000 gain x 32% (short term gain rate) = $19,200 tax liability