An online broker might charge a $10 commission to execute a stock trade. Your cost to buy 100 shares of a $50 stock would be $5,000 plus $10.

Trade commissions reduce before-tax gain

The commission would amount to only 0.2% of the principal invested. A few months later, you sell the stock for $60. As before, you would incur a $10 commission.

After subtracting the commission costs, you net $980 before taxes. The commission has reduced your net gain by a full 2 percent.

Short-term capital gains tax far exceeds commission cost

A short-term gain brings on a tax that lowers its return by 35 percent if you are subject to the top marginal tax rate. The capital gains tax on a $980 short-term gain would total $343.

This tax cost is 17 times greater than the round-trip commissions cost.

Long-term tax rate still takes a big bite

Had you held the stock more than one year before selling, the capital gain would be long-term. Such a long-term gain is taxed at only 15 percent.

For a $980 long-term gain, the capital gains tax would total $147. Waiting to realize a long-term capital gain results in a tax cost more than 7 times that of the trade commissions.

Delay capital gains tax by delaying a stock sale

A trivial way to delay the tax cost is to delay selling the stock. While the gain remains unrealized, it incurs no costs. Unless your asset allocation plan dictates that you dispose of the position, holding an unrealized gain is the best method for lowering your investment costs in the current year.

A dollar today is worth more than a dollar next year. Postponing the tax leaves you with more cash to invest now and discounts the tax cost in a future year.

Avoid the tax by offsetting the capital gain with a capital loss

Actually, capital gains tax is not calculated individually for each stock sale. If you must sell a stock with a short-term capital gain, you might look for another holding that has an unrealized short-term capital loss.

Selling another stock with a $1,000 short-term loss will more than offset the $980 short-term gain. This would leave you with zero net capital gains tax.

Rather than waiting until you have a gain that you want to realize, you may want to employ tax loss harvesting to recognize those losses as they arise. No investor sets out to lose money after buying a stock. Those who hold onto those losses when they could use them to offset gains miss a certain way to lower their tax.

How many times have you heard someone say, “You don’t have a loss until you sell”? If that were true, it would also hold true for capital gains. Few investors will dismiss their unrealized gains as mere paper gains.

Handle unrealized capital gains to your advantage

Recognizing a capital gain triggers a capital gains tax, at short or long-term rates. In a taxable portfolio, the effective value of all unrealized gains should be discounted due to the potential tax. Avoiding or delaying recognition of a gain preserves the gain and avoids the tax.

Long-term capital gains get a favorable 15% tax rate. Even so, that cannot compare with the zero rate on unrealized gains. Whether short or long-term, the best approach to handle capital gains: do not disturb them. At some point in the future, when you really need the funds, your capital gains will still be there.

Paper gains are the best.

Benefit from recognizing a capital loss

No investor sets out to buy a stock that will fall in value. Nevertheless, any stock position carries such a risk.

Selling a stock for a capital loss provides a tax benefit. To exercise that benefit, you must sell the stock. Sitting on an unrealized loss will not change the loss. The harm in doing nothing, though, is giving up the tax benefit from recognizing the loss.

An unrealized capital loss is real. Take it.

WFMI (Whole Foods Market, Inc) had a 2 for 1 stock split on December 28, 2005. Before the split you bought 300 shares of WFMI at $60 per share.

Realize a capital gain

During 2008 you sold 200 WFMI shares for $20 each and realized a sale amount of $4,000. To figure the capital gain (or loss), you need to determine the cost basis of the sale.

After searching your trade history, you find the 300 share purchase with a trade amount of $18,000 (300 shares times $60). The WFMI position had a cost basis of $60 per share before the split.

The sale of 100 shares prior to the split did not change the cost basis per share. After that sale the 200 shares of WFMI had total cost basis of $12,000 (200 shares times $60).

A stock split leaves total cost basis unchanged

The stock split had no effect on the $12,000 total cost basis. The 200 shares received due to the stock split did halve the cost basis per share to $30 ($12,000 divided by 400 shares).

The sale during 2008 of 200 shares would have a cost basis of $6,000 (200 shares times $30 per share). Thus, you realized a long-term capital loss of $2,000.

A tax lot clarifies the effect of a stock split

A 300 share purchase would create a new tax lot with a cost basis of $18,000. This tax lot would have its shares reduced to 200 by a sale. The sale would lower the total cost basis to $12,000. At $60, the cost basis per share would remain unchanged.

After a 2 for 1 stock split, the share quantity of the tax lot would double to 400. The total cost basis would stay the same. With twice as many shares, the cost basis per share would halve to $30.

Divide split shares among tax lots for multiple purchases

Your portfolio might include several WFMI purchases with share quantities of 250, 350 and 400. The broker would report that you have received 1,000 shares due to the stock split.

The cost basis and holding period for the added shares correspond to each of the three purchases. Without using tax lots, sorting out the cost basis of various shares can become a burden.

Short-term losses directly offset short-term gains. Investors can also use the net capital loss to lower their ordinary income by as much as $3,000. In the best case for those subject to the top 35% marginal tax rate, a $3,000 capital loss could reduce the tax due by $1,050. Taxpayers in lower tax brackets see smaller tax reductions, though.

How to dilute the tax reduction value of a short-term capital loss

Suppose that year to date, an investor’s portfolio has already realized a net short term capital loss of $3,000. The portfolio also has $10,000 of unrealized long term capital gains.

If she sells stock to realize a $3,000 long-term gain, the short-term loss will offset the gain. This leaves her with zero net capital gain. With zero gain, she has zero capital gains tax due.

Had there been no short-term loss, the $3,000 long-term gain would have incurred a tax of $450 (15% times $3,000). By offsetting the gain, the net short-term loss has also offset the $450 tax. Used this way, the $3,000 loss is ‘worth’ only $450. She has wasted $700 of the potential value of the short-term loss.

Delay long-term gains to years without short-term losses

The investor might have a better choice in this situation. Suppose she waited until the next year to realize the $3,000 long-term gain. Without a loss to offset the gain, the capital gains tax would be $450 (15% times $3,000). In the prior year, her $3,000 capital loss lowered her tax by $1,050. Looking at both years together, her net capital gains tax would be a negative $700 ($450 minus $1,050). She has recovered the full potential of the $3,000 short-term loss by avoiding its offset against a long-term gain.

Early each year, investors receive a ‘Proceeds from Broker Transactions’ report, IRS Form 1099-B, from each of their brokerages. This form lists the gross proceeds from stock sales for the prior year.

The bad news: the Form 1099, with just the sales listed, provides only a part of the data needed to determine the capital gains for Schedule D. For each sale, the amount of capital gain, or loss, is the difference between the gross proceeds and the ‘cost or other basis’.

Cost basis depends on which stock was sold

From IRS Pub 550, the cost basis for a stock position is the purchase price plus any purchasing costs such as commissions. To know the purchase price, one needs to identify which stock was sold. When an investor has made purchases at various times, this can become difficult.

Identify stock sold with tax lots, not stock trade history

Every opening trade to purchase stock creates a new tax lot. The cost basis of the lot is the purchase price plus any purchasing costs.

Later, a sale of stock will reduce the number of shares in the lot being sold. When all of the shares are sold, the lot is closed. If only a portion of a lot is sold, the lot will have its shares reduced by the number of shares sold. The cost basis is the fractional part of the shares sold to the total cost basis of the lot.

A sale of stock may also involve multiple lots. Each lot will have a distinct cost basis and holding period. Such a sale will result in a separate capital gain or loss for each affected lot.

Cost basis record keeping is a burden

The taxpayer bears the responsibility for tracking the cost basis to substantiate their capital gains. Along with a list of current stock positions, brokerage reports include the history of trades. Except for the simplest cases, neither coincides with the tax lots.

Investors have few tools to help track cost basis over time. Many use tax preparation software to calculate capital gains at year-end. While this may appear to be a reasonable approach, this may not result in the lowest tax.

Some do maintain a record of each tax lot in their portfolios. Nevertheless, taking on this task with a spreadsheet would be time-consuming and error-prone.

A cost basis app for individual investors

A great cost basis app would make tax lots easy. Investors who know their tax lot situation can make better trades year-round. This helps them get better after-tax returns, since they trade stock with an eye on lowering their capital gains tax. With the tax lots already set up, calculating the capital gains and Schedule D becomes automatic.

Providing investors with a simple tool to maintain their tax lots is another reason why we developed the Realized app for managing stock portfolios.

An investor has purchased 200 shares of a stock at four different times:

• 18 months ago at $16 per share
• 14 months ago at $23
• 10 months ago at $24
• 6 months ago at $17

Today the latest quote for the stock is $20. His brokerage account shows the 800 share position as having a market value of $16,000.

Selling stock using FIFO

Because the stock has not performed as well as he hoped, he has decided to sell half of the position for $20 per share.

He will use FIFO, or first-in, first-out, as the cost basis for the sale. This results in two distinct capital gains. For the shares purchased 18 months ago, he has an $800 long-term gain (200 shares times $4 per share). In addition, he will have a $600 long-term loss (200 shares times $3 per share) for the shares purchased 14 months ago.

For the sale, he will have a net long-term gain of $200. This will incur a capital gains tax of $30, ($200 times 15%).

Selling the stock lots with the highest cost basis

Instead of using FIFO, he could have sold the stock having the highest basis. Rather than two gains, this would result in two capital losses. For the stock with the highest basis, purchased 10 months ago, he would have an $800 short-term loss (200 shares times -$4 per share). Selling the next highest basis stock, purchased at $23, would result in a $600 long-term loss (200 shares times -$3 per share).

Altogether, he would realize a $1,400 capital loss by using HIFO, or highest-in, first-out cost basis. Since he falls into the highest marginal tax bracket of 35%, this loss would reduce his tax by $490 ($1,400 times 35%).

In either case, he still holds 400 shares of stock. Selling the highest basis stock has lowered his tax by a net $520 ($490 plus $30). As mentioned in a previous post, to use HIFO an investor must make an adequate identification of the stock being sold.

Review each tax lot before selling

Each closing trade may produce various taxable outcomes. As we saw above, this is notably true for stock positions composed of multiple purchases, or tax lots.

A typical brokerage account will display each position’s current market value and the share quantity. This is not enough. Without knowing the cost basis of each lot being sold, an investor has no idea what the prospective capital gain might be. By relying on FIFO as his cost basis, he risks incurring capital gains tax that might have been avoidable.

Instead, imagine him already having an estimate of the expected capital gain, prior to placing a trade order. With that information in hand, he could place a trade with a specific capital gain outcome already in mind.

Providing investors with that insight (and more) is one reason why we developed the Realized app for managing stock portfolios.

Diversification can dampen losses

An investor has decided to diversify by holding 10 stocks in a $100,000 portfolio. To balance the portfolio, he bought equal amounts, or $10,000, of each stock.

After three months, the total value of the portfolio has not changed. Two stocks have dropped 25% to just $7,500. On the plus side, one stock is up 50% to $15,000.

Having that gain to offset the losses shows the power of diversification. Without the $5,000 gain, the overall portfolio value could have dropped to $95,000.

Market action degrades diversification

The relative weight of the $15,000 holding has risen to 15% ($15,000 divided by $100,000). Now, the portfolio is far more sensitive to a price change in that stock.

Both of the $7,500 holdings are underweighted. Due to their small size, they now have less influence on the future performance of the portfolio.

Rebalancing could trade a potential risk for a certain cost

Equalizing the weights would restore the measure of diversification. To begin, he sells one-third, or $5,000, of the $15,000 holding and realizes a short-term gain of $1,670 (one-third of the $5,000 gain). The gain also incurs a tax of $580 ($1,670 times 35%). From the proceeds of the sale, he now has $4,420 in cash.

He then adds to the two $7,500 holdings by buying $2,210 of stock in each. While he has succeeded in balancing the portfolio, its value has dropped to $99,420, due to the tax.

Bringing a single over-weighted stock back to its target weight has cost the portfolio $580. Repeating this action each quarter might present too high a price to keep the stock weighting balanced.

Offset the balancing cost by taking a loss

Instead of adding to both of the $7,500 holdings, he could have sold one of them. Recognizing a $2,500 short-term loss would more than offset the gain.

Better yet, the net loss of $830 ($1,670 minus $2,500) would provide a tax reduction of $290. The tax penalty for rebalancing has just vanished.

Not counting the tax savings, he now has $12,500 in cash from the proceeds of the two sales. With that, he could buy $10,000 in a different stock. To adjust the weight of the remaining $7,500 holding, he could also add $2,500 in stock.

But after considering the lower tax, he would also have $290 to spare.

An earlier post mentioned that the holding period for a capital gain affects its tax rate. Short-term capital gains get taxed just like ordinary income. This rate can rise as high as 35% for taxpayers in the top bracket. For long-term capital gains, the tax rate is much lower: 15%.

The huge cost of a short-term gain

Eleven months ago, an investor bought 300 shares of stock at $40. The latest market price for the stock is $50. Her $12,000 investment is up 25% and is now worth $15,000. If she sells now, she has a $3,000 short-term capital gain.

In the top tax bracket, the gain would incur a tax of $1,050 ($3,000 times 35%). Subtracting the tax leaves an after-tax gain of $1,950. Instead of being up 25%, her after-tax return has fallen to about 16%.

Save tax if a long-term gain is near

She might wait a month or so before selling. By doing so, she does risk a fall in the market price. But after holding the stock more than a year, she may get another chance to sell the stock at $50. Such a long-term gain would have a tax of $450 ($3,000 times 15%).

Holding the unrealized gain until it became long-term has saved $600 in tax ($1,050 minus $450).

This $600 in after-tax savings amounts to 20% of the $3,000 before-tax gain. When a long-term gain is imminent, one should carefully consider the cost of selling too soon. In other words, taking a short-term gain could cost an investor 20% of their before-tax return.

Note that the Tax Increase Prevention and Reconciliation Act of 2005 extends the 15% rate for long-term capital gains only through December of 2010. Beginning in 2011, long-term capital gains will incur a 20% tax rate.

Holding period for stock matters greatly, because stock held long-term incurs a lower tax rate when sold. If a stock is held more than one year, the capital gain is long-term.

A sale on the first anniversary of the purchase is short-term

To have a short-term gain, or loss, the stock must be held one year or less. The holding period begins on the day after the trade date and includes the trade date of the sale.

When the sale trade date is prior to the first anniversary of the day after the purchase trade date, a short-term gain, or loss, results.

For a stock purchased on April 30, 2008, the holding period begins the next day, May 1, 2008. A sale of that stock for a gain on April 30, 2009 will realize a short-term gain. Waiting until May 1, 2009 to sell will produce a long-term gain.

Leap years follow the same rule

Consider a stock purchased on Feb 28, 2011. If this stock were sold on Feb 29, 2012, the holding period would still be short-term. In this case, the holding period would have begun on March 1, 2011.

An investor may purchase a company’s stock at various times and in varying quantities. When part of that stock is later sold, the capital gain is the difference between the sale amount and the cost basis of the stock.

If multiple purchases occurred, the IRS considers the default cost basis to be the amount paid for the stock purchased first. This is also known as FIFO, or first-in, first-out. In a taxable portfolio, relying on FIFO cost basis may raise your capital gains tax. This can do real damage to your after-tax return.

Capital gain using FIFO

Six months ago an investor bought 200 shares of stock for $27 per share. Three months later she bought 200 more shares of the same stock for $33 per share. Today she sold 200 shares at $30. The sale amount is $6,000 (200 shares times $30).

Using FIFO, the cost basis of the stock purchased first is $5,400 (200 shares times $27). The capital gain, sale amount minus cost basis, is $600. This short-term gain is taxed at the marginal rate of ordinary income. With that rate at 35% for many investors, the tax is $210.

When is FIFO cost basis not the right choice?

Using FIFO is easy, and most tax software uses it as a default for stock cost basis. If investors had no other choices for cost basis, this would not be a problem.

But, they do. A different choice would have been to sell the stock purchased later at $33. The cost basis for the later purchase is $6,600 (200 shares times $33). Rather than a gain, the sale would realize a loss of $600. Instead of paying tax, the loss would offset other gains or ordinary income and lower her tax by $210.

By selling the stock bought later, she lowered her current year tax burden by a net $420.

Minimize gains by selling the stock with the highest basis

The change from a costly taxable gain to a loss happened by choosing not the later, but rather the higher cost basis. HIFO, or Highest-In, First-Out, cost basis takes a smaller gain now and defers the larger gain into the future.

In both cases, what remains is a stock position of 200 shares worth $6,000. The differences are the current year tax and the unrealized gain.

With FIFO, the remaining cost basis is from the later purchase, or $6,600. The investor owes $210 in tax and is sitting on an unrealized loss of $600.

Using HIFO, the investor has lowered her tax by $210 and holds an unrealized gain of $600. The lower tax provides $420 more for reinvestment. Further, she may choose not to sell that stock for a number of years, thereby deferring the tax.

Opting out of FIFO cost basis for stock sales

To repeat, the IRS considers FIFO the default cost basis for stock sold. To use HIFO, an investor must make an adequate identification of the stock being sold. Some call this method specific identification.

An investor has no control over market movements, but she can control when she sells stock. By also pinpointing what to sell, she gets a new tool to lower her tax and raise her after-tax return.