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Capital gains and losses (Schedule D)

Click for accompanying notes, and online audio samples from our tape on income tax planning.

Schedule D

After reporting small business or self-employment income on Schedule C, report any capital gains or losses on Schedule D. A lot of people won't have any capital gains transactions, but if you sell securities or other capital assets held outside a retirement account, you'll have to fill out Schedule D.

And don't worry, the IRS has devised a system to help remind you of the need to report capital gains transactions. If you sell any securities, your broker or mutual fund should send you a 1099-B which lists the proceeds of the sale.

Since the 1099-B lists the proceeds of the sale, you'll have to include at least the gross proceeds on Schedule D. However, the 1099-B currently doesn't show the actual gain or loss you realized. For that, you're largely on your own.

Your cost basis in an asset

When it comes to capital gains calculations, your so-called basis in the property is important. In it's simplest sense, your basis is the cost of the property. But your basis can be adjusted up or down depending on circumstances.

Let's say you invested $1,000 in a mutual fund whose shares were selling for $10. Your $1,000 investment gives you 100 shares. Further assume that you made this investment in early January.

The fund moved up over the year, and on December 15 of the same year the fund distributed to you $60 in dividends. You reinvested these dividends in 5 shares of the fund when the fund was $12 a share. A few days later, on December 20 you sold all your holdings in the fund because you thought the market would go down.

Assume your selling price was $12 a share, so your sale of 105 shares at $12 a share yielded $1,260. Your mutual fund then sends you a 1099-B which shows $1,260 in gross proceeds.

So what's your total gain on the sale? You invested $1,000 back in January, so your reportable gain is $260, right? Wrong.

Add reinvested dividends to your cost basis

Your reportable gain is actually only $200, not $260. That's because the $60 in reinvested dividends are added to the basis of your holdings like any additional purchase.

So your cost basis in the mutual fund is the original $1,000 investment plus the $60 in reinvested dividends, or $1,060. When you subtract this from your gross proceeds of $1,260, you get a net gain of $200.

And in case you're wondering, you do have to pay taxes on the $60 in distributed dividends that you received. The $60 in dividends are reported on a 1099-DIV, and are taxed on Schedule B.

So if you reinvest your mutual fund dividends but don't adjust your cost basis up, you'll wind up paying taxes twice on that dividend. You'll pay ordinary income taxes once when the dividend is distributed, and capital gains taxes once when you sell if you don't adjust your cost basis up.

Unfortunately, calculating your capital gains can get difficult. The example I gave was simple, but imagine if your mutual fund makes monthly distributions, and you buy and sell chunks of the fund during the year. Determining your cost basis in this case can get complicated.

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How to calculate cost basis (average, FIFO, specific)

To help you determine your capital gain or loss, many of the larger mutual funds are sending so-called average cost data sheets to their investors. These greatly simplify your calculation of capital gains or losses because you already know the proceeds, and the fund company tells you the average cost.

There are, however, several ways to determine the cost basis for mutual fund shares that you sell. One is the average cost basis. Another is the first-in-first-out or FIFO method. This is the IRS default method.

A third is the specific shares method. In this case you tell your mutual fund, usually through a letter, which shares you want to sell. If you want to minimize your gain, you sell the shares which have the highest cost basis.

Average cost is overall best method

Assuming the share price of your fund generally goes up, the IRS default method of FIFO results in the highest tax, the specific shares method can yield the lowest tax, and the average cost method yields a tax between the other two.

You can choose to calculate your cost basis with any of the three methods, but once you've started to use a method, you must continue to use that method until you completely cash out of the fund. So which method is the best to use?

Of the three methods, I'd use the average cost method in most cases, especially if your mutual fund already provides you with this information. I'd use the average cost method for bond funds or stock funds that don't show large capital gains.

If you use the average cost method, you might have to pay a little more in capital gains taxes, but you'll save yourself some tedious calculations. However, if you have a fund that has large capital gains, using the specific shares method can save you a lot in taxes.

Don't worry about cost basis for retirement accounts

Finally, remember that this whole discussion only applies to securities held outside of a retirement account. You can have plenty of mutual funds, stocks, bonds, and trade to your heart's content inside a retirement account. As long as they're inside a retirement account, you won't have to pay a cent in capital gains taxes.

You will, however, eventually have to pay ordinary income taxes when you pull your money out in retirement. Still, you won't have to worry about your cost basis for retirement accounts because your cost basis in retirement account assets is usually zero. That is, everything you pull out is subject to taxes at ordinary income rates.

Since ordinary income rates historically have been higher than capital gains rates, you may pay a little more in taxes in the future. But retirement accounts overall offer great tax savings, so you should invest in retirement accounts first, and then in unsheltered mutual funds or other securities second. See my tape on mutual funds for more information on the tax aspects of various funds.

Capital gains on home sales

And don't think all this talk about capital gains taxes is only for the so-called rich. If you own a home, you'll have to worry about capital gains taxes. Whenever you sell a home, you'll have to report it on Form 2119, which flows into Schedule D.

Although you'll have to worry about calculating your cost basis and realized gains, you may not have to actually pay taxes when you sell your home, especially if you trade up to a larger home.

Assume you paid $100,000 for a home in 1990. In 1993 you spent $10,000 to add a room in the basement. You sold the house in 1996 for $150,000 after sales commissions.

Normally, under these circumstances, you'd have a taxable gain of $40,000. That's the $150,000 from the sale, minus your cost basis of $110,000. Note how the addition of the room raised your cost basis by $10,000. Make sure to keep records of these improvements for as long as you own a home.

However, if you buy a new home for more than the net selling price of your old home, you can defer that $40,000 gain. So if you buy a new home that costs at least $150,000, you won't owe any taxes.

Note these numbers are only approximate because of slight changes due to selling expenses and "fix-up" costs like painting your old home. Still, you generally can defer paying much or all of your capital gains taxes on the sale of your home.

Also note that politicians currently are talking about eliminating capital gains taxes on home sales because the record keeping is complex and the tax doesn't generate much revenue.

But until passage of a new law, you'll have to console yourself with a truly once-in-a-lifetime goodie for older folks who sell their home. If you sell your home after age 55, you can take advantage of a one-time, once-per-couple exclusion of up to $125,000 in gains that you've accumulated in your home.

Body text copyright 1997 by David Luhman