That horrible crash you heard today? It was the market. And it was not pretty. The Dow fell 630 points today, marking the worst day for investors in three years.
As a result, you can’t swing a cat without some kind of market analysis. Except here. Between you and I, I don’t know enough about the subtleties of the market to know who to blame more, so I won’t. And I will cling to my Pollyanna view of life and assume that the market will eventually recover, despite the dark and foreboding warnings from the media.
All of that said, I do have something to say (like you expected different).
What has been made clear to me over the past few weeks – between today’s market fall and the certain end of the world that was the debt ceiling crisis – is that we sometimes throw around phrases that have very specific meanings without considering whether they’re actually applicable. It was particularly apparent to me when I heard analyst after analyst refer to capital losses. I kept thinking of the scene in The Princess Bride when Inigo Montoya says to Vizzini: “You keep using that word. I do not think it means what you think it means.”
So let’s go over some basics:
- Basis. Basis is, at its most simple, the cost that you pay for assets. The actual cost is sometimes referred to as “cost basis” because you can make adjustments to basis over time. When it comes to stocks, your basis is generally equal to the original cost of the shares; if you participate in a DRIP or other reinvestment plan, your basis is your cost plus the cost of each subsequent purchase/reinvestment (subject, of course, to other adjustments for splits and the like).
- Taxable event. A taxable event is a sale of stock, death of an owner or other specified event that is said to trigger a tax consequence.
- Realized gain/loss. A gain or loss has to be realized in order to mean anything for tax purposes and this is where some taxpayers get confused. Just because the market goes up or down – as it has this week – doesn’t actually mean anything for tax purposes. Even if your stocks tumbled hundreds or thousands of dollars in this latest roller coaster ride, it means nothing to Uncle Sam unless one of those taxable events mentioned above happened. Did you sell the stock? Did someone die holding those stocks? If not, then relax, because for tax purposes, nothing has happened. I know from an investment purposes, it stinks, but simply holding onto the stock during a volatile market does not equal a taxable event, and thus there’s no capital gain or loss.
- Capital gains. If your realized gains exceed your realized losses, you have a capital gain which is taxable (the rate will be dependent on whether those gains or losses are long term or short term).
- Capital losses. If your realized losses exceed your realized gains, you have a capital loss for tax purposes. You can claim up to $3,000 (or $1,500 if you are married filing separately) of capital losses in any tax year. The loss offsets your taxable income for the current tax year.
- Schedule D. You’ll report your gains and losses on a Schedule D, and then transfer the results to the reconciliation page on your federal form 1040. You don’t file a Schedule D if you don’t have any shares subject to a taxable event – even if the value of your shares went up and down.
- Short term gains or losses. If you hold the shares for one year or less and then sell or otherwise dispose of the stock, your capital gain or loss is considered short-term. Short term gains are generally taxed at your ordinary income tax rate which, for 2011, vary between 10% and 35%.
- Long term gains or losses. If you hold the shares for more than one year before you get rid of them, your capital gain or loss is called long-term. For 2011, the highest tax rate on a net long term capital gain of regularly traded stock is 15%.
- Loss Carry-forward. If your losses exceed the allowable limits for any tax year, you can carry the loss forward to later years subject to certain limitations.
So now that you have the basics, let’s check out a quick example:
Assume you buy a stock for $10. Over the year, assume that the value of that stock climbs to $20 due to the market (and not any additional investment on your part).
You continue to hold the stock. Result? No capital gain.
The stock takes a hit and falls to $15. No capital loss.
The stock takes a hit and falls to $7. You continue to hold the stock. No capital loss.
The stock tumbles to $4. You finally get rid of it. You have a capital loss of $6 ($4 selling price – $10 basis). You take the loss at the basis, not the high price; the $20 high value is meaningless for purposes of capital gain or loss. That seems to be the sticking point for many taxpayers. You want it to mean something. But it doesn’t. At least not for tax purposes.
The reality is that capital gains and losses can be confusing. But let’s not make them more confusing than they need to be. In a plunging market, your portfolio may lose value but unless you’re trading or selling off, you’re not actually realizing those losses for tax purposes.
A quick note: this is meant to be a quick and dirty primer on capital gains and losses for shares of regularly traded stocks. There are a bunch of exceptions for small businesses, retirement assets and other circumstances, as well as adjustments related to calls, puts and straddles. There are also special rules for artwork, real estate and other assets, especially as they relate to capital losses and carry forwards but those are way beyond the scope of this piece.
So breathe. There’s a lot going on in the markets these days. But deal with the crises as they come – and don’t manufacture ones where they don’t exist. If you still have questions about what all of this means to you, call your tax professional – your broker will enjoy the break.