Selling Shares to Your Best Advantage
If the federal taxes due on your 1995 investment earnings made you reel, you might want to do some planning for 1996.
What can you do?
* Choose your method. If you acquired shares in a company over time--buying a few shares every few years, for example--and then opted to sell only a portion of your holdings, determining your taxable gain can be tricky because there are two ways to calculate it--the “specific-shares” method or the “first-in, first-out,” or FIFO, method.
With the specific-shares method, you can designate which securities you’re selling (for tax purposes) by writing a letter to your broker at the time of sale that spells out your wishes. That can give you greater flexibility to manage gains and losses to the best tax advantage.
For instance, let’s say you bought 100 Walt Disney Co. shares two years ago when the stock was at $40 and you bought 100 more shares last fall, when the stock price was $60. You decide to sell 100 of your shares when the market price hits $63. If you specify that you’re selling the more recently purchased shares--and put that in writing at the time of sale--your taxable gain works out to just $3 per share, minus trading fees.
If you don’t explicitly state that you’re using the specific-shares method, the Internal Revenue Service will determine your gain using the first-in, first-out method, which assumes that the first shares you sell are the first shares purchased. The end result: Your taxable gain is $23 per share, or $2,300, rather than $300.
* The method matters more to mutual fund investors. If you sold a partial stake in a mutual fund, determining your cost basis can be even more complex simply because you have more options. The IRS allows you to choose among four methods--FIFO and specific shares, as discussed above, and “average cost-single category” and “average cost-double category.”
The average cost-single category method simply involves adding up the number of shares you own, divided by the total amount you paid, to come up with an average cost of each share. You then calculate your gain by subtracting the sales price, minus costs and commissions, from the average cost.
Average cost-double category is similar, but you divide your investment into groups based on whether they are short- (owned less than a year) or long-term holdings. You then determine average costs for each.
The most popular option is the average cost-single category, partly because most mutual fund companies now calculate this average for you.
* Consider circumstances as carefully as convenience. While it may be easiest to use the average cost provided by your fund company, some taxpayers can save money by using a different method. Moreover, once you use the average-cost method, you’re stuck with it until you sell off your entire holding--or until the IRS gives you permission to switch methods.
To illustrate how the other cost-calculating methods might pencil out, consider a hypothetical high-income taxpayer, Blaine Bigshot, who has been purchasing shares in XYZ mutual fund since 1993.
Bigshot’s dollar-cost-averaging program involves buying 500 shares every three months at the going market price. He starts investing in the fall of 1993, when XYZ is selling for $40 a share. But XYZ’s price falls to $30 in December of 1993 and stays there until near the end of 1994. Then XYZ’s share price climbs to $35 in December, $40 in March of 1995 and $55 in June, but drops back to $50 in September. Bigshot sells 500 shares in December at $50 a share.
What’s his taxable gain? If he uses FIFO, his gain is $5,000 because he’s selling the first shares he bought--the $40 shares from 1993--resulting in a $10-per-share profit.
If he uses the average cost-single category method, he’ll report a $6,110 profit because his average cost is $37.78, making his net profit $12.22 a share.
If he uses the average cost-double category method, he’d have to specify whether he’s selling his long-term holdings or his short-term holdings. If he sold the long-term holdings, his profit would amount to $9,000. If he sold the short-term holdings, it would be just $2,500, but he’d have to pay tax at his ordinary income tax rates--36% for Bigshot--rather than the more attractive 28% capital gains rate.
However, if he used the specific-shares method, he could specify that he was selling the shares purchased in June at $55. Instead of posting a capital gain, he’d have a $2,500 capital loss, which could reduce his taxable gains from other investments or be used to whittle down his ordinary income. Bigshot saves between $700 and $900 in federal tax, depending on how he is able to use his capital loss.
* Give what has appreciated most to get the biggest tax bang for your charitable buck. Bigshot also planned to give a big gift to charity at the end of 1995. However, instead of giving cash, he gave stock in XYZ. And when he asked his broker to transfer shares, he specified that the broker should give the charity the 1,000 shares that he purchased in March and June 1994 for $30 a share.
Because these shares are now worth $50, Bigshot gets to deduct $50,000 on his federal tax return even though he paid just $30,000 for those shares. Since he’s giving the shares to a tax-exempt organization, no one has to pay tax on the $20,000 gain.
* A final note. Make sure you keep good records, establishing when you bought, sold or gave away each individual security, tax accountants advise. These records are imperative for executing a savvy strategy, and they will be worth their weight in platinum if you’re ever audited.
