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If there is one certainty in life, it’s taxes – Uncle Sam has to have his share. And when it comes to investing, the Feds, as well as state and local governments, have their hands in many places. One of them happens to be when it comes to capital gains.
Capital gains taxes can burn on a variety of fronts. From holding periods to various corporate events, the buying and selling of investments can be tricky. And one wrong move can impact taxes in a big way. But investors do have some tools at their disposal.
And one of them is understanding their “cost basis.”
While a simple concept, keeping track of a portfolio’s cost basis can help reduce, defer and even potentially eliminate taxes all together. It’s one of the best tools we have to help keep Uncle Sam at bay.
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At its core, the cost basis is pretty easy to understand. It’s basically the initial value or purchase price of an asset or investment. So, if you buy 10 shares of XYZ stock at $10 per share, your cost basis for the lot of stock would be $10 per share or $100 total. This information is valuable and required if you ever need to sell that lot of stock. When it comes to capital gains, taxes are owed on the difference between this original cost basis price and what you sell the asset for.
That’s really the basics. The problem is, a variety of things can impact that cost basis and change it – both initially and over time.
For example, initially that cost basis includes any brokerage fees, sales loads on mutual funds, and any other trading costs acquired during purchase. These help to push the cost basis up and reduce taxes later on. However, with the growth of free trading, zero-load mutual funds and overall lower initial investment costs, the effect is starting to dwindle.
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At the same time, dividend investors need to understand their cost basis because various corporate actions can impact this initial purchase price over time. Actions such as mergers, stock splits and dividend payments can affect the cost basis. This is especially true if you reinvest those dividend payments. These reinvested dividends can create a plethora of stocks with different initial bases.
Mutual fund and other asset class owners, such as master limited partnerships (MLPs), have a few other things to worry about when it comes to cost basis. For mutual funds, unrealized gains inside the mutual fund that have not been distributed to shareholders can shift cost basis around. MLP distributions themselves are tax-deferred by their structure, so instead, they reduce an investor’s cost basis until the asset is sold.
Essentially, the changes in cost basis does one thing, and that’s either reduce or increase the amount of taxes you owe Uncle Sam. Given that short-term capital gains taxes can be as high as 39%, understanding your cost basis and how to minimize taxes is critical.
Luckily, starting in 2011, the government required brokerages and asset managers to keep track of cost basis for shareholders. If you bought your investments before that, you need to do some calculating on your own and check your statements.
That cost basis data on your brokerage statement is a wealth of information that can be used to help reduce your taxes. First, time of purchase should be considered. Older lots that have been held over a year qualify for the lower long-term gains rate. But even here, different lots can have different tax rates given the initial cost basis. Investors do have some choice to help reduce taxes further beyond short- vs. long-term gains. This comes down to method of sale, and there’s basically three ways to do that.
The real goal of using the different methods and your cost basis is to reduce taxes on sales of assets. By looking at your various initial costs, you can come up with a game plan for owing less taxes and even engage in strategies like tax-loss harvesting.
Uncle Sam gets his way. Taxes are a guarantee.
Understanding how your cost basis works for your investments can be a vital tool in order to reduce your taxes. By looking at your investment statements, selecting the right security lots and selling assets in a favorable manner, you can keep more of what you gained.
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