Capital Gains for Stocks and Mutual Funds

Study Notes:

What are tax lots?

Each purchase of a security creates a tax lot. For example, if on January 15 you buy 100 shares of XYZ
stock for $100, that is one tax lot. If on January 17 you buy 100 shares of XYZ stock for $90, that creates
a separate tax lot. Separate tax lots can be created with purchases within the same day of the same
security.

Why are tax lots important?

Tax lots are used to determine cost basis and holding period for US tax. US tax law mandates that you
sell securities by tax lot. Average cost (averaging the purchases of all shares over time) is only allowed
for mutual funds and securities that have participated in Dividend Reinvestment Plans (DRIPs). Some
brokers do not support cost basis reporting for average cost and use the standard tax lot reporting.

Tax lot methods for recognizing capital gains

Tax lots are used to identify exactly what is being sold at what time. Technically, in the US Tax Code
there are two methods of using tax lots to determine gains/losses and holding period: The default
method is First In, First Out. The oldest lot – or first purchase – is deemed to be the first one sold.
The second method is specific identification – that is where the owner specifies to the broker what lot is
to be sold. This must be done before the settlement of the transaction. What about the algorithms that
determine what to sell to either maximize loss or holding period? These are program scripts that review
the tax lot and specifically identify what should be sold mathematically. They are just automated
versions of the specific identification method.

Holding Periods

There are two holding periods used to determine the US tax rate for capital gains. Over the years the
length of these has changed, but the general concept has remained the same.
Short-term capital gains/losses occur on tax lots that you have held less than a year and one day from
the trade date.

Long-term capital gains/losses are anything held over a year and a day.

Remember that this applies to tax lots or each individual purchase, so that if you have three different
purchases of a security on three consecutive dates and decide to sell it one year from the middle day,
only the first purchase will be long-term.

It is a common misconception that a year is March 2 to March 2, for example. However, for tax
purposes, the day of purchase (trade) does not count for a security. In order to receive long-term
treatment, you must own it for a year and a day.

Gains versus Losses – How do they offset?

When computing tax on gains and losses there is an ordering as to how they offset one another. Short-term gains are first offset by short-term losses. Likewise, long-term gains are offset by long-term losses.

If there are short-term and long-term gains, they are taxed at their respective rates. It there is a short-term loss, it offsets long-term gains and the remaining gain is taxed at the long-term rate. If there is a
long-term loss, it offsets the short-term gain and the remainder is taxed as ordinary income.

Net loss is limited to $3,000 per year to offset income other than capital gains, such as wages, interest
and dividends. Any loss in excess of $3,000 is carried forward to the next year (or beyond, until used
against gains).

Tax Rates

Short-term capital gains are taxed at ordinary income tax rates. Long-term capital gains are taxed at 0%,
15% or 20% depending on your adjusted income.