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Capital Gains, Minimal Taxes

"How do people become wealthy? ... Capital Gain is the source of most wealth." Kaye Thomas

Capital Gains, Minimal Taxes

The Essential Guide for Investors and Traders

By Kaye A. Thomas

If you invest in stocks and mutual funds, you'll want to buy a copy of Capital Gains, Minimal Taxes: The Essential Guide for Investors and Traders by Harvard tax attorney Kaye Thomas. Thomas is also the founder of the highly-regarded investment tax site, The Fairmark Tax Guide for Investors (

In clear and simple language, Capital Gains, Minimal Taxes explains most investment-tax-related topics investors need to understand, ranging from calculating your basis on stocks and mutual funds to maximizing the allowed tax deduction for a capital loss.

Because taxes consume a substantial chunk of ordinary income, many knowledgeable investors wish to maximize their investment in things which are taxed at the more favorable capital gain tax rates (currently 10% for investors within the 15% income tax bracket and 20% for investors whose entire income falls above the 15% income tax bracket).

Thomas begins by working several examples to show investors how to calculate their tax burden given their tax bracket and the amount of their short-term and long-term capital gains and losses from stocks and mutual funds.

For example, Thomas writes: "Example. Before you take capital gains and losses into account, your taxable income is $2,000 below the upper boundary of the 15% bracket. You have a short-term capital gain of $2,000 and a short-term capital loss of $500, giving you a net short-term capital loss of $1,500 In addition, you have a long-term capital gain of $3,800 and a long-term capital loss of $1,300, giving you a net long-term capital gain of $2,500."

"The short-term capital gain counts first. You're in the 15% tax bracket with $2,000 to spare, so the entire short-term gain of $1,500 is taxed at the 15% rate. After that, you're only $500 away from going into the next tax bracket. That means $500 of your long-term gain will be taxed at 10% and the rest will be taxed at 20%." (Capital Gains, Minimal Taxes).

After explaining how to calculate your tax burden under all the various scenarios (net short-term capital gain with a net long-term capital gain; net short-term capital gain with a net long-term capital loss; net short-term capital loss with a net long-term capital gain; net short-term capital loss with a net long-term capital loss), Thomas devotes a chapter each to the special rules which apply to the taxation of individual stocks and mutual funds.

Thomas shows that, sometimes, we can lower the capital gains tax paid by identifying the specific shares of individual stock being sold. For example, suppose we buy 100 shares in Company XYZ at $10 per share on July 1, 1999. We buy 100 more shares of XYZ at $20 per share on July 9, 2000. We then sell 100 shares of XYZ on July 19, 2001 for $30 per share.

Unless we specified otherwise at the time of the sale, Thomas tells us that from a tax standpoint the shares sold will be treated on the first-in-first-out basis (FIFO). We will be taxed on a net long-term capital gain of $20 per share. However, had we identified the shares sold as those purchased on July 9, 2000, we would be taxed on only a net capital gain of $10 per share. Thomas explains the two things that must happen to ensure that the identification of shares will be deemed valid by the IRS.

Thomas writes: "The rules for identifying shares aren't difficult, but are often misunderstood. It isn't just investors who mess up: many brokers get confused by these rules. Make sure you understand them, so your broker's ignorance won't cost you tax dollars."

Calculating your adjusted basis in a stock or mutual fund and properly determining your holding period is covered in detail with numerous examples. While Thomas tells us that few investors will use the identification of specific shares method when selling shares of a mutual fund, Thomas explains the different ways that you could elect to have your mutual fund shares taxed upon sale. These methods include single-category averaging and double-category averaging. Thomas discusses the advantages and disadvantages of each method. He also explains how mutual fund dividends and capital gain distributions are taxed.

In another chapter, Thomas shows us how to calculate taxation, the holding period, and the basis for shares purchased through a dividend reinvestment plan. With many purchases over many years, such a computation can prove tedious. Thomas says it's crucial to keep good records of your investments to aid in the calculations.

While Capital Gains, Minimal Taxes does a great job explaining the basics of investment taxation, it also does an outstanding job of explaining the more complex and confusing aspects of the taxation of stocks and mutual funds. With some topics, Thomas not only explains what the IRS code says and what it means, but how it is usually misinterpreted, and what the IRS really meant the tax code to say, anyway. Then, Thomas gives his views of what the tax law should be in regard to the topic.

For example, in a detailed chapter about the Wash Sale Rule, Thomas explains that while the Treasury Code still states that the Wash Sale rule doesn't apply to traders, Congress has changed the law. The Wash Sale Rule does apply to traders. The Treasury regulations just haven't been updated yet.

The Wash Sale Rule is designed to prevent investors from getting a tax deduction upon selling shares which have dropped greatly in value, when the investor immediately repurchases the same shares to hold the same investment position. Thomas shows us how basis and holding period are affected by a wash sale. And, he addresses the popular question, "Does the Wash Sale Rule apply if I sell stock at a loss and repurchase the stock within my IRA?"

Thomas gives his opinion of the Alternative Minimum Tax (AMT). Thomas writes: "The basic idea behind the alternative minimum tax is a good one: people with very high levels of income shouldn't be able to completely avoid paying income tax while the rest of us pony up each year. The AMT is a poor reflection of that idea, however. Many high-income individuals escape its reach-and every year it ensnares more and more people who were never intended to be affected."

Employees who had massive gains followed by equally massive losses on their employee stock options are one example of people who would have benefited by knowing the tax laws better. As you've probably read in the news, some individuals have gone from being wealthy to not having enough total wealth to pay their current tax liability, compliments of the AMT not playing nicely with employee stock options.

While Thomas briefly touches upon the topic of employee stock options in Capital Gains, Minimal Taxes, he doesn't go into detail. Another bestselling book by Thomas, Consider Your Options: Get the Most from Your Equity Compensation, addresses employee stock options.

Thomas writes, "It's worth noting that you can end up with a gain that's greater than the amount of money you realize in a sale. That's one reason to plan carefully when you use debt to acquire investment assets. You may have to come up with money from other sources to pay the tax on your gain ...There's only one thing worse than having to report gain that's greater than your net sale proceeds, and that's having the tax itself be greater than the net sale proceeds."

Thomas suggests that you consider making voluntary, estimated tax payments, if you know the tax liability will materialize, even if the estimated tax payment isn't legally required. Thomas says that giving up some interest by holding the money a little longer might not be as valuable as the peace of mind of knowing that your tax liability is covered.

Other topics discussed in Capital Gains, Minimal Taxes include:

· Tax rules for gifts

· Capital loss carryovers

· Taxation of stock acquired from a spouse

· Separation, divorce, and who gets custody of the basis

· Stock dividends and splits

· Taxation of mergers and spin-offs

· Stock that has become worthless (especially useful with the dot-com implosion)

· Qualified small business stock

· Planning for lower taxes

· Making estimated tax payments

· Custodial accounts for minors and special issues affecting child investors (Yes, Thomas tells us that, technically, your five-year old can sign his tax return, but you might not want this...)

· Tax deductibility of Investment Expenses and Investment Interest

Throughout Capital Gains, Minimal Taxes, Thomas gives us tips for not inadvertently losing valuable tax deductions. And, he shows us ways investors could potentially save thousands of dollars through a little tax planning.

For example, upon inheriting stock, we learn that the basis of the stock is changed to its fair market value on the date of the giver's death. So, by holding a greatly appreciated stock and passing it on to heirs, we can eliminate taxes on all the capital gain that occurs between the original purchase and the end of our lives. While stock basis can "step up," Thomas explains that the reverse can also occur.

Suppose we had originally purchased stock for $20,000, but today the stock is only worth $2,000. If we die and the stock is inherited, the basis steps down to its market value of $2,000. No one gets to take the tax deduction for the $18,000 capital loss. Thomas notes that investors tend to sell their winners too early and their losers too late.

Advanced chapters also cover the taxation of stock options, short positions, writing puts and calls, and the taxation of active stock traders. I don't recommend stock options, short selling, and day trading to individual investors, so I just skimmed those chapters. Most conservative investors can safely skip these advanced chapters.

Thomas explains the two tests used to determine if an investor is a trader. Because of the unique nature of the way that stock traders are taxed, Thomas compares traders to a platypus.

Thomas writes: "When the first platypus was brought from Australia to England, people figured it had to be a hoax. Here was an animal that had to be considered a mammal because it had fur and fed its young on breast milk-yet it had a flat bill and webbed feet like a duck, and laid eggs. The idea was preposterous, and the more you knew about biology, the more likely it was you would refuse to believe such an animal existed."

"At the risk of offending traders, I compare them to the duck-billed platypus, at least when it comes to taxes. The tax treatment of traders is a unique mixture of rules for investors and rules for businesses:

· Traders don't sell goods or services to customers, yet they're considered to have a business.

· Despite having a business, traders don't pay self-employment tax on their income.

· Traders report deductions on Schedule C (used for business) but report their trading income on Schedule D (used for capital gains and losses). As a result, Schedule C nearly always shows a loss, even when the trading activity is profitable.

The more you know about taxes, the stranger these characteristics seem. Like a mammal that lays eggs, trader taxation simply doesn't fit anything we know about the world." (Capital Gains, Minimal Taxes).

While I'll leave the taxonomy of day traders to the tax professionals, I consider myself a fairly knowledgeable and savvy investor, and I learned a great deal about the taxation of investments by reading Capital Gains, Minimal Taxes. This book belongs in every serious investor's library. Remember, each dollar saved in taxes adds directly to your wealth.

Capital Gains, Minimal Taxes
Capital Gains, Minimal Taxes:
The Essential Guide for Investors and Traders

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