Gains on dispositions of what the IRS terms "investment property", which includes stocks and options, are taxable as capital gains, if not held in retirement accounts. Further, losses sustained on such dispositions can offset gains, and subject to limitations, can be used to offset other income, if losses exceed gains. Investors are universally aware of these seemingly straight-forward facts. But, as we shall see, there are many considerations and complications to take into account when determining capital gains and losses and how to properly report them on a tax return.
Definition of Long-Term Holding Period, Benefits of Long-Term vs. Short-Term
Most investors are well aware that gains which can be classified as long-term per the IRS definition are taxed at a lower rate than short-term gains, which are taxed the same as ordinary income. Investors are advantaged if gains are long-term and losses are short-term. As noted in Part I, for 2012, long-term gains will be subject to a maximum rate of 15%, and depending upon total income and other factors, may have some of all of the gains not taxed at all. Even if the rules revert to what they were prior to the Bush tax changes, long-term gains will still receive favorable tax rates, compared to ordinary income.
Thus, properly determining the holding period is critical. The rule is, to be considered a long-term gain, the stock must have been held longer than one year, or more precisely, twelve months. Twelve months plus a day or more qualifies, while twelve months exactly, or less, does not. The trade date is the day to reference for stocks in most cases. The time lag between the trade date and the settlement date is not a factor. The starting day of the holding period is the day after the trade date, while the ending day of the holding period is the sale date, which is the trade date when the stock was sold.
Be aware that the holding period is figured in months and fractions of months. If the holding period began on a given day in a month, the holding period is increased by one month upon reaching that same numerical day in each succeeding month. The number of days in a month is not considered. If a stock was acquired on the last day of a month, the holding period increases by one month upon reaching the last day of each succeeding month.
An exception to using the trade date as the applicable date is when closing a short position. In some cases, the delivery date is the purchase date to report. See Part IV, Short Sales, for more on this.
If shares were purchased in lots, on different dates, and the sale was not of the entire position, the IRS, and the brokerages reporting cost-basis on Form 1099-B, will consider that the shares sold were the oldest held. In other words, first-in, first-out (FIFO) is assumed as a default. Note that an average cost of shares cannot be used for stocks. (Exceptions, beginning in 2012, are ETFs structured as regulated investment companies, or shares acquired via a dividend reinvestment plan.)
To override FIFO treatment, the IRS has historically required that an investor must give instructions to the brokerage as to which shares are to be sold, and must receive written confirmation of same from the brokerage. Many, if not most, retail brokerages now allow investors to specify which shares are to be sold as part of the sale order entry process. Schwab and E*Trade are two examples. Presumably, if an investor makes an election to override FIFO using these tools, the brokerage will report the sale accordingly, and the IRS will accept it. I have not, I should point out, confirmed this assumption.
Understanding New Brokerage Reporting Requirements on Form 1099-B
Beginning in 2011, brokerages have been required to report the cost-basis and holding period for stocks acquired after 12/31/2010 to the IRS and to the account owner, on Form 1099-B or substitute. The data reported will depend upon whether a transaction was covered or not, as indicated by Box 6. Covered transactions are those for which all data is reported. Uncovered transactions are those for which a sale occurred in the tax year, but the acquisition date was prior to the beginning of 2011, or the type of security is not required to be fully reported, such as an option (options will be required to be reported beginning with tax year 2013). Uncovered transactions will not show values for all items. Data reported is as follows:
- Box 1a - Date of Sale.
- Box 1b - Date of Acquisition. Not shown for uncovered transactions.
- Box 2 - Sales Price. Must indicate whether a gross sales price is shown, or is net of commissions and transfer taxes.
- Box 3 - Cost or Other Basis. Not shown for uncovered transactions.
- Box 4 - Backup Withholding, if applicable. Usually only applies if a TIN was not supplied by the account holder.
- Box 5 - Amount of Loss Disallowed Because of Being a Wash Sale. Not shown for uncovered transactions.
- Box 6 - Indicates whether Covered or Uncovered.
- Box 8 - Type of Gain or Loss, Long-Term or Short-Term. Not shown for uncovered transactions. Note that there is, inexplicably, no Box 7, at least on all the 1099-B forms I have received.
- Box 9 - Description. Usually the Corporation Name for a stock. Also shown will be the CUSIP Number and the Quantity.
- Boxes 10 through 13 - Data relating to Regulated Futures Contracts.
- Box 14 - Related to proceeds from a Barter Exchange.
- Box 15 - If checked, indicates a loss shown cannot be taken. Usually applies to wash sales.
As mentioned in Part II, Dividends, capital gains on certain commodity ETFs, such as the popular GLD and SLV ETFs, are considered to be collectibles by the IRS, and gains are treated differently than for stocks, per the rules for collectibles. The long-term rate for collectibles can be as high as 28%. Forms 1099-B may or may not flag these as requiring different tax treatment. Also, in researching this, I read that investors have noted that even though holdings in these ETFs were not sold during a year, small, incremental sales were reported on the 1099-B.
These are the result of incremental sales by the ETF. The resource stated that they are reportable as gains by the taxpayer, and offsetting expenses are also reportable, but only as miscellaneous itemized deductions. Further clarification is beyond the scope of this article series. Investors should research these issues thoroughly and understand the ramifications before investing in these unique vehicles in taxable accounts.
In prior years, Form 1099-B showed a limited amount of data for sales transactions, primarily the Sale Date and the Gross Proceeds from the sale. This alerted the IRS that capital gain or loss activity occurred, and provided a figure for reconciling the Gross Proceeds totals as reported by the taxpayer on Schedule D. But, obviously this was far short of providing the IRS with enough data to quickly determine if there was a potential capital gains reporting shortfall. Only a detailed audit could uncover failure to report capital gains properly. The new 1099-B reporting requirements, combined with new Form 8949, effectively tightens up the reporting requirements, and reduces the possibility of significant capital gains escaping taxation.
Introduction to Form 8949 and Relationship to Schedule D
One article I read stated that with Form 8949, the IRS has effectively deputized taxpayers to become associate accountants, assigned to reconcile the data reported by brokerages on Forms 1099-B and report the results to the IRS.
Completing Form 8949 is a prerequisite to completing Schedule D. The details of trades are shown on Form 8949, and totals from all of the Forms 8949 are then transferred to Schedule D, to determine the taxable gain or loss. There are potentially six versions of Form 8949 that may be required, and any of these six versions can run to multiple pages. At the highest level, Form 8949 breaks down transactions between Short-Term, shown on Part I, and Long-Term, shown on Part II. Under each of these two major categories, transactions are segregated and reported appropriately under three potential sub-categories, which indicates the status of the transactions shown on that page, as far as how they were reported on Form 1099-B, and also possibly to the IRS, is concerned.
The status is indicated by checking box A, B, or C. If A is checked, the transactions are reported fully on Form 1099-B, and the cost-basis was reported to the IRS. If B is checked, the transactions were reported on Form 1099-B and to the IRS, but cost-basis was not reported. The form instructions state that Box C is to be checked if neither Box A nor Box B applies. This could mean anything, but I would interpret it to be any transactions that involve capital gain or loss which occurred that were not reported on the forms with Boxes A and B checked. It is incumbent upon the taxpayer to report all capital gains and losses, regardless of whether or not reported on forms 1099-B received.
The essence of the detailed reporting is that the data is to be shown exactly as it was reported on 1099-B in the applicable columns, and any errors or discrepancies are to be rectified with an adjustment, along with a specific code identifying the reason for the adjustment. Columns of Form 8949 are as follows:
- (a) Description - Usually the quantity and security description. Certain types of transactions have variations.
- (b) Code - Indicates a reason for an adjustment. If a transaction requires multiple adjustments due to multiple errors, all applicable codes are to be indicated.
- (c) Date Acquired - For a long stock position, the trade date. Certain types of transactions have variations.
- (d) Date Sold - For a long stock position, the date the position was sold, the trade date of the sell order being filled. Certain types of transactions have variations.
- (e) Sales Price - Most commonly, the net sales proceeds, after commissions and transfer taxes, for example, for a long stock position sold. If gross sales proceeds are reported by the brokerage on 1099-B, an adjustment will be required, to be explained momentarily.
- (f) Cost or Other Basis - For a long stock position, includes purchase commission, and must be reduced by any return of capital distributions. If seems unlikely to me that the brokerage reporting will show reductions in cost-basis from return of capital distributions, particularly if these distributions have gone on for awhile. The taxpayer will need to make an adjustment if this situation has occurred.
- (g) Adjustment Amount - Positive or negative, depends upon the type of adjustment.
Note that Date Acquired through Cost Basis must be exactly as shown on Form 1099-B, with one exception; if the Form 1099-B has an incorrect Date Acquired or Date Sold, show the correct dates on Form 8949, and indicate Code T. If the error causes the transaction status to change from Long-Term to Short-Term or vice-versa, report the transaction on the proper Form 8949 page applicable, considering the corrected dates.
Some of the most common adjustments are:
· B - Basis is incorrect. The amount to show is an amount that when netted with the basis shown will yield a correct basis. Thus, if the basis shown is overstated, show the amount by which it is overstated as a negative number. If understated, show the amount by which it is understated as a positive number.
· T - Dates are incorrect. See note above on how to handle. Adjustment amount will be zero unless other errors are present.
· W - Wash sale loss disallowed. Show the amount of the disallowed loss as a positive number. This will cause the loss to be excluded from capital gains reporting.
· L - Other non-deductible loss. Show the amount of the non-deductible loss as a positive number. Effect will be the same as W adjustments.
· O - Used when sales proceeds do not include selling expenses, such as sales commissions and transfer taxes on stock sales. Show the total sales expenses as a negative number. This will serve to reduce the amount realized from the sale from the gross figure reported on 1099-B. O is also used as a catch-all code for errors not properly classified otherwise. Positive or negative will depend on the nature of the adjustment.
If there are multiple errors with multiple adjustments, show all applicable codes, and net the adjustments into one number and enter into the adjustment amount column.
Once all Forms 8949 are completed, the summarized results are then folded into Schedule D, and the taxable gain or loss is calculated per the Schedule D instructions. To receive the proper rate on long-term gains, the proper worksheet(s) must be completed, as outlined in the Schedule D instructions. If the end result of Schedule D is a loss, only a maximum of $1500 (single filer) or $3000 (joint filer) can be used to offset other income. Any excess can be carried forward to be used in the Schedule D process in succeeding years.
Resources and Disclaimer
All of the preceding is based on my review of the following resources:
J.K. Lasser's Your Income Tax for 2013, available from bookstores everywhere.
Taxes and Investing Brochure from the Options Clearing Corporation (OIC), available as a PDF file online here.
Various IRS Publication, particularly the 1040 instruction booklet, along with instructions for Schedules A, B, C, D, and E, and Publication 550, Investment Income and Expenses. A link to the IRS website is provided here.
Article from Bogleheads.org regarding tax issues with GLD and SLV ETFs is linked here.
While I have made a good faith effort to understand and present the topics discussed in this article, relying upon the resources cited, I want to reiterate that I am not a financial professional, nor am I certified in any way as a financial advisor or tax expert. I am an independent, individual investor, focusing on dividend-paying stocks exclusively. I am always seeking to become more knowledgeable on investments and related topics, and on sharing what I have learned with other investors in similar circumstances. Also, I want to reiterate a caution mentioned in the first paragraph of Part I and in the Disclaimer section of all succeeding articles, which is that the points I am bringing out are limited to commonly occurring situations that investors in publicly traded stocks and options experience, with positions held "in street name" in brokerage accounts. Readers need to realize that the information as presented is not all-inclusive, and that there are many exception conditions and special cases that are not being discussed.
Investors are advised to seek professional tax advice and assistance in handling their own tax situation. However, becoming a knowledgeable and conversant client on tax issues affecting investors will save time and money, and will improve the likelihood of correct tax filings.
The next topic in this series is devoted to issues relating to stock buys and sells that can cause unexpected consequences for an unaware stock investor / speculator. Specifically, wash sales, short sales, and constructive sales of appreciated financial positions. Coming up next is Part IV - Wash Sales, Short Sales, and Constructive Sale Rules.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.