Cost Basis and Capital Gains

Are you filing a tax return soon that includes income from investments? While stock market indexes have fallen dramatically in the last two weeks, many investors had capital gains in 2019 and are paying income taxes on them now. To calculate what you owe, you must understand some key terms like “cost basis” and “capital gain.” Below are five essential things to know:

Cost Basis- Cost basis is the amount paid for an investment including reinvested dividends and mutual fund capital gain distributions that are taxed in the calendar year that they are received. For example, if you buy 100 shares for $3,000 and, over time, reinvest dividends of $250 to buy additional shares, your cost basis is $3,250.

Capital Gain- A capital gain is the increase in value of a capital asset such as real estate or investments (e.g., stocks, bonds, exchange-traded funds, and mutual funds). In other words, people realize capital gains when they “buy low” (e.g., stock purchased for $10 a share) and “sell high” (e.g., stock sold for $20 a share). The difference between the cost basis of an asset and the amount for which it was sold is the capital gain (or loss).

Holding Period- Capital gains (or losses) may be short-term or long-term. A short-term capital gain is a gain on capital assets held for a year or less and a long-term gain is a gain on assets held more than one year. Both types of capital gains must be claimed on tax returns that determine an investor’s tax payment, but they are taxed very differently.

Taxation- Short-term capital gains are taxed as “ordinary income,” i.e., income based on an investor’s marginal tax rate, determined by tax filing status (e.g., single, married filing jointly, head of household, etc.) and household taxable income. Long-term capital gains are taxed at a lower capital gains tax rate ranging from 0% to 20%, depending on an investor’s taxable income and tax filing status. Ideally, investments should be held long term to receive more favorable tax treatment.

Tax Withholding- It is wise for investors, especially those with significant assets, to monitor their tax withholding status. If additional withholding is needed to cover taxes due on capital gains, investors have two possible strategies. One is to set aside a portion of their investment profit to pay quarterly estimated taxes to the IRS. The other is to adjust their W-4 form at work to have their employer take more tax withholding out of their paychecks with which to pay investment-related taxes.