I swear it is better to stuff your mattress with your money.
That was a comment from one of my friends today after she took a peek at the market. It’s been a volatile day. Within minutes of the opening bell, the Dow Jones industrial average plummeted more than 1,000 points. That was reportedly the largest drop ever on a trading day. As of this writing, the market had recovered significantly but was still off about 400 points from the open.
The wild ride, and the fact that numbers for the Dow Jones are still low for some stocks, make it easy for folks like my friend to think that they’ve “lost” money today. But strictly speaking, they’ve haven’t. What they have is an unrealized loss, sometimes called a paper loss.
Stocks go up and down: it’s the nature of the beast. And while we hope they go up more than they go down, statistically, there are going to be dips. But every time the market dips, that doesn’t equal a real, or realized loss. Similarly, when the market goes back up, that doesn’t equal a real, or realized gain. To realize a gain or a loss for accounting purposes, you have to do something with the stock. Typically, that means that you sell it or otherwise dispose of it. The same is true for tax purposes.
Even if you were to sell your stock today, just because it was worth less this morning than when you went to bed last night doesn’t necessarily mean you’ll have a realized loss. For tax and accounting purposes, gains and losses aren’t determined moment to moment but instead how much your cost basis has gone up or down from the time you acquired the asset to the disposition of the asset.
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. When you dispose of the asset at sale or transfer, sometimes called a taxable event, the value of the stock or asset at that moment is what matters. Nothing else matters. It doesn’t matter if the stock went up and down a hundred times in the middle. Your realized gain or loss is figured by calculating the difference from purchase (plus adjustments) to sale. All that stuff in the middle is, for tax and accounting purposes, just a bunch of squiggly lines.
At tax time, you’ll report your realized 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 realized gains or losses: even if the value of your shares went up and down significantly, if there’s no sale or disposition, there’s nothing to report.
- If your realized gains exceed your realized losses, you have a capital gain that is taxable; the rate will be dependent on whether those gains or losses are long-term or short-term. If you hold the shares for one year or less and then sell or otherwise dispose of the stock, your capital gain is considered short-term. Short term gains are generally taxed at your ordinary income tax rate. If you hold the shares for more than one year before you get rid of them, your capital gain is called long-term. The highest tax rate on a net long-term capital gain of regularly traded stock is typically 20%.
- 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 amount of your loss offsets your taxable income for the tax year. If your losses exceed those limits, you can carry the loss forward to later years subject to certain limitations. Some other limits and restrictions apply depending on the kind of assets: for example, you may not claim a capital loss for a personal residence.
Here’s a quick example to help you sort out the math:
Assume you buy a stock for $100. Over the year, assume that the value of that stock climbs to $250 due to market conditions and not any additional investment on your part.
You continue to hold the stock. Result? Unrealized gain. No capital gain.
The stock takes a hit and falls to $85. Unrealized loss. No capital loss.
The stock takes another hit and falls to $25. You continue to hold the stock. Unrealized loss. No capital loss.
The stock climbs back up to $75. You finally get rid of it. You have a capital loss of $25 ($75 selling price – $100 basis). You take the loss at the basis, not the high price (the $250 high value is meaningless for purposes of capital gains or losses) nor at the low price (the $25 low value is similarly meaningless for purposes of capital gains or losses). 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 volatile market, your portfolio may go up and down but unless you’re trading or selling off, you’re not actually realizing those losses for tax purposes.
A quick note: capital gains and losses can be super complicated. Exceptions and special rules may apply to 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.