As we wrap up the functional changes that we discovered during the Realized app beta testing, one new feature stands out. Early on, we saw that stock splits complicate the calculation of capital gains. One of the first features built into our automated tax lot setup included the handling of stock splits.

For any lot affected by a stock split, the Realized app will calculate the number of post-split shares. This requires no effort on the part of the user.

Mergers and tax lots needed a solution

During the beta test, we came across the merger of WYE (Wyeth) with PFE (Pfizer). The merger is actually a taxable acquisition using both PFE shares and cash boot.

We wondered how the thousands of WYE shareholders calculated the cost basis in their new PFE shares. Depending upon the cost basis for each of their pre-merger WYE tax lots, many had taxable capital gains, even though they sold no WYE stock. Some avoided the headache and passed the problem on to their tax accountants.

To provide our customers with full automation of the tax lot process, we went forward with adjusting tax lots for mergers. Going beyond the WYE/PFE merger, different merger types (either all stock, all cash or stock plus boot) require different handling. The end result: Realized will effortlessly maintain the cost basis for all tax lots, including stocks going through mergers.

No more headaches.

Public launch imminent

If all goes according to plan, next week we will begin a preview period during which anyone may setup a Realized account. To receive a notification when the preview begins, go to www.realized-app.com.

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.

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.