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The Investment FAQ (part 15 of 20)

( Part1 - Part2 - Part3 - Part4 - Part5 - Part6 - Part7 - Part8 - Part9 - Part10 - Part11 - Part12 - Part13 - Part14 - Part15 - Part16 - Part17 - Part18 - Part19 - Part20 )
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Archive-name: investment-faq/general/part15
Version: $Id: part15,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

See reader questions & answers on this topic! - Help others by sharing your knowledge
The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance.  This is a plain-text
version of The Investment FAQ, part 15 of 20.  The web site
always has the latest version, including in-line links. Please browse

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for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.  

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly.  Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it.  Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers.  Readers outside the USA can reach
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Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Strategy - Survey of Stock Investment Strategies

Last-Revised: 20 Jan 2000
Contributed-By: John Price (johnp at

This article offers a brief survey of several strategies that investors
use to guide their stock purchases and sales. 

Before we start the survey, here's a golden rule of investing: Know why
you are buying a particular stock -- donít wait until its price goes up
or down to think about it.  Many investors are not sure why they bought
a stock in the first place, so when a dramatic fall in price happens,
they're not sure what to do next. 

Here's an example.  Let's say you bought Intel.  When you know why you
bought Intel you will have a stronger basis for knowing what to do when
its price goes up, or down, or even stays the same.  So if Intel starts
to go down in price and you bought it as a momentum play, then you will
probably want to sell as quickly as possible.  But if you bought it as
an undervalued stock, and if the fundamentals have not changed, then you
might want to buy more."

Of course, every investor and every stock presents a different reason
for contacting your broker.  But we have to start somewhere, so here is
my analysis of the six main investment styles. 

Brother-in-law investor
     Your brother-in-law phones, or perhaps your stockbroker or the
     investment writer for the regional newspaper.  He has the scoop on
     a great stock but you will have to act quickly.  If you are likely
     to buy in this situation, then you are a "brother-in-law investor."
     Brother-in-law investors rely on the advice of other people to make
     their decisions. 
Technical investor
     Moving averages, candlestick patterns, Gann charts and resistance
     levels are the sort of things the technical investor deals with. 
     Technical investors were once called chartists because their
     central activity was making and studying charts of stock prices. 
     Nowadays this is usually done on a computer where advanced
     mathematics combines with grunt power to unlock past patterns and
     correlations.  The hope is that they will carry into the future. 
Economist investor
     This type of investor bases his decisions on forecasts of economic
     parameters.  A typical statement is "The dollar will strengthen
     over the next six months, unemployment will decrease, interest
     rates will climb -- a great time to get into bank stocks." Random
     walk investor This is the area of the academic investor and is part
     of what is called Modern Portfolio Theory.  "I have no idea whether
     stock XYZ will go up or down, but it has a high beta.  Since I
     donít mind the risk, Iíll buy it since I will, on the average, be
     compensated for this risk." At the core of this strategy is the
     Efficient Market Hypothesis EMH.  There are a number of versions of
     it but they all end up at the same point: the current price of a
     stock is what you should buy, or sell, it for.  This is the fair
     price and no amount of analysis will enable you to do any better,
     says the EMH.  With the Efficient Market Hypothesis, stock prices
     are assumed to follow paths that can be described by tosses of a
     Scuttlebutt investor This approach to investing was pioneered by
     Philip Fisher and consists of piecing together information on
     companies obtained informally through wide-ranging conversations,
     interviews, press-reports and, simply, gossip.  In his book Common
     Stocks and Uncommon Profits, Fisher wrote:
          Go to five companies in an industry, ask each of them
          intelligent questions about the points of strength and
          weakness of the other four, and nine times out of ten a
          surprisingly detailed and accurate picture of all five
          will emerge. 
     Fisher also suggests that useful information can be obtained from
     vendors, customers, research scientists and executives of trade
Value Investor
     In the fourth edition of the investment classic _Security
     Analysis_, the authors Benjamin Graham, David Dodd, and Sydney
     Cottle speak of the "attempts to value a stock independently of its
     current market price".  This independent value has many names such
     as `intrinsic value,í `investment value,í `reasonable value,í `fair
     value,í and `appraised value.í They go on to say:
          A general definition of intrinsic value would be "that
          value which is justified by the facts, e.g., assets,
          earnings, dividends, [and] definite prospects, including
          the factor of management." The primary objective in using
          the adjective "intrinsic" is to emphasize the distinction
          between value and current market price, but not to invest
          this "value" with an aura of permanence. 
     Value investing is the name given to the method of deciding on
     individual investments on the basis of their intrinsic value as
     contrasted with their market price. 
     This, however, is not the standard definition.  Most authors refer
     to value investing as the process of searching for stocks with
     attributes such as a low ratio of price to book value or a low
     price-earnings ratio.  In contrast, stocks with high price to book
     value or a high price-earnings ratio are called growth stocks. 
     Investors searching for stocks from within this universe of stocks
     are called growth investors.  These two approaches are usually seen
     to be in opposition. 
     Not so, declared Warren Buffett.  In the 1992 Annual Report of
     Berkshire Hathaway he wrote, "the two approaches are joined at the
     hip: Growth is always a component in the calculation of value,
     constituting a variable whose importance can range from negligible
     to enormous and whose impact can be negative as well as positive."
Conscious Investor
     This type of investor overlaps the six types just mentioned. 
     Increasingly investors are respecting their own beliefs and values
     when making investment decisions.  For many, quarterly earnings are
     no longer enough.  For example, so many people are investing in
     socially responsible mutual funds that the total investment is now
     over one trillion dollars.  Many others are following their own
     paths to clarify their investment values and act on them.  The
     process of bringing as much honesty as possible into investment
     decisions we call conscious investing. 

Most people invest for different reasons at different times.  Also they
donít fall neatly into a single category.  In 1969 Buffett described
himself as 85 percent Benjamin Graham [Value] and 15 percent Fisher

Whatever approach, or approaches, you take, the most important thing is
know why you bought a particular stock.  If you bought a stock on the
recommendation of your neighbor, be happy about it and recognize that
this is why you bought it.  Then you will be more likely to avoid the
"investor imperative," namely the following behavior: If your stock
rises, claim it as your ability; if it falls, pass on the blame. 

Do all that you can to avoid going down this path.  Write down why you
bought a stock.  Tell your spouse your reasons.  Tape them on your
bathroom mirror.  Above all, if you want to be a successful investor,
donít kid yourself. 

For more insights from John Price, visit his site:

--------------------Check for updates------------------

Subject: Strategy - Value and Growth

Last-Revised: 23 Oct 1997
Contributed-By: Chris Lott ( contact me )

Investors will frequently read about value stocks (or value strategies)
as well as growth stocks (and growth strategies).  These terms describe
reasons why people believe certain stocks will increase in value.  This
article gives a brief summary. 

The value strategy attempts to find shares of companies that represent
good value (i.e., value stocks).  In other words, their stock prices are
lower than comparable companies, perhaps because the shares are out of
favor with Wall Street.  Eventually, they believe, the market will
recognize the true value of the stock and run up the price.  People who
believe in this strategy are sometimes called fundamentalists because
they focus on the fundamentals of the company.  The grand champion of
this strategy is (was) Benjamin Graham, author of two classic investment
books, Security Analysis and The Intelligent Investor.  Measures of
value may be a company's book value, earnings, revenue, brand
recognition, etc, etc. 

The growth strategy attempts to find shares of companies that are
growing and will continue to grow rapidly (i.e., growth stocks).  In
other words, their earnings are increasing nicely and the stock price is
increasing along with those earnings.  People who believe in this
strategy are sometimes called momentum investors.  They are sometimes
criticized for paying high prices for growth and ignoring fundamentals. 
Measures of growth usually focus on the earnings growth. 

With just a little bit of looking, it's easy to find mutual funds that
take one, the other, or a combined strategy. 

--------------------Check for updates------------------

Subject: Tax Code - Backup Withholding

Last-Revised: 20 Mar 1997
Contributed-By: John Schott (jschott at

Once the IRS declares you a "Bad Boy" (for having underpaid or been
negligent on your tax filings in other ways) they stick you with "Backup

What this means, essentially, is that any firm that deals with your
money in taxable tranactions is required to withhold (and submit to IRS)
31% of the proceeds of ANY transaction (on the assumption that the
entire amount is a taxable gain).  Then, next year when you file, they
have all this money of yours, and you might be able to get it back if it
is in excess of your actual tax liability once they have themselves
determined it is indeed excess. 

So if you trade often, 31% disappears each time and soon all of your
capital is held by the IRS. 

I think that your time in the "penalty box" lasts for 5 years (I'm not
sure) if you remain faultlessly clean and petition to have it lifted. 

In short - this is not something you want to get into.  By the way,
there is a substantial penalty if you lie to the broker about whether
you are subject to this treatment. 

--------------------Check for updates------------------

Subject: Tax Code - Capital Gains Cost Basis

Last-Revised: 7 Jan 2000
Contributed-By: Art Kamlet (artkamlet at, Chris Lott ( contact
me )

This article discusses how to determine the cost basis of a security
according to the rules of the US tax code.  The most common need for the
cost basis of a security like stock is to report the proper gain or loss
when that security is sold.  This article sketches the issues for the
simple case (you bought a security) and a couple less simple cases (you
are given or inherit a security).  Of course you might have not just one
share but instead many hundreds; the word "security" is used here for

You bought the security
     The cost basis is simply the money you paid when you bought the
     security, including any commissions that you paid to acquire that
     security.  For example, if you bought 10 shares of IBM at 100 and
     paid $29.95 in commission to do so, your cost basis would be
     1029.95.  This example lists just a single purchase of a security. 
     If you accumulated stock over the course of many purchases, the
     total cost basis is still just the cost of all the purchases
     including commissions.  The situation gets a bit more complex if
     you sell only a portion of an investment; see the FAQ article about
     computing capital gains for more information about this. 
You were given the security
     To oversimplify the issue, if the shares are given away at a gain,
     the donor's cost basis and acquisition date are used.  If the
     shares are given away at a loss, the fair market value as of the
     date of gift must be used to calculate a subsequent sale at a loss,
     while the donor's cost basis must be used to calculate a subsequent
     sale at a gain.  In the case of a gift at a loss, which is later
     sold at a loss, the date of the gift is used as the "acquisition
     date" of that stock.  All of this means that an individual can
     transfer a gain but not a loss to another individual.  Read on for
     all the details. 
     The date when the gift is made is important.  To figure the cost
     basis, the fair market value (FMV) of the gift on the gift date
     must be determined.  A local library's microfilm archive might be
     the best resource to find the value of shares on a particular date. 
     But be cautious about stock splits and other stock dividends! It's
     wise to consult the S&P stock guide, the Value Line Investment
     Survey, or the company that issued the shares for a history of the
     stock price, stock splits and dividends, etc. 
     In the happiest and simplest case, the donor bought shares for a
     pittance, and donated them to some lucky individual, maybe you,
     after the shares had appreciated dramatically.  That individual
     immediately sold the shares.  The fair market value (FMV) of the
     shares on the gift date far exceeded the original cost basis, so
     the recipient's cost basis is the same as the donor's cost basis
     (possibly small, but definitely NOT zero). 
     For example, the donor's cost basis is $20, and the FMV on the date
     of the gift is $100.  The cost basis that the recipient must use is
     $20.  On the other hand if the shares were sold for only $5, the
     same cost basis is used, and the loss is $15.  In both cases, the
     acquisition date that must be reported is the same as the donor's
     acquisition date. 
     The other possibility, of course, is that the share's FMV on the
     gift date was less than the original cost basis thanks to some
     decline in value.  In this case, the gift assumes a dual cost basis
     that is not determined until the shares are sold.  The donor's cost
     basis must be used to determine the gain if the shares are sold at
     a gain.  The FMV on the date of the gift must be used if the shares
     are sold at a loss. 
     For example, the donor's cost basis is $20, and the FMV on the date
     of the gift is $10, thus establishing a dual cost basis.  Here are
     three possibilities. 
        * Case 1: If the shares are subsequently sold for $25, this is a
          gain with respect to the donor's original cost basis and the
          FMV, so the recipient consequently reports a gain of $5,
          namely $25 (sales price) less 20 (donor's cost basis). 
        * Case 2: If the shares are sold for $8, this is a loss with
          respect to the donor's original cost basis and the FMV, so the
          recipient consequently reports a loss of $2, namely $8 (sales
          price) less $10 (FMV on gift date). 
        * Case 3: Here's where it gets complicated.  If the shares are
          sold for $15, representing a loss with respect to the donor's
          cost basis but a gain with respect to the FMV on the gift
          date, what cost basis should the recipient use?
             * If the donor's cost basis of $20 is used, this would
               produce a loss for the recipient.  However, the $20 can
               be used only when the recipient has a gain, so that's
             * If the FMV of $10 is used, this would produce a gain for
               the recipient.  However, the $10 can be used only when
               the recipient has a loss, so that's out too.  Result: The
          recipient has neither a gain or loss. 
     The acquisition date that must be reported depends on the cost
     basis, and is pretty straightforward.  If the donor's cost basis is
     used, use the donor's acquisition date, and if the FMV on the date
     of the gift is used, use the date of the gift. 
     The IRS is light on advice as to how to report a transaction where
     the stock was given at a loss, and the sale produces neither gain
     nor loss.  If you report the net sales price and then show the cost
     basis equal to the sales price, you end up with no gain.  You can
     choose to use either the date of gift or original date as your
     acquisition date, since no gain or loss makes it a pretty much
     "don't care" condition. 
You inherit a security
     The cost basis is simply the value of the security on the date of
     the person's death who bequeathed that security to you.  (The
     accountant lingo for this is "when the stock was inherited, its
     cost basis was stepped up to fair market value on date of death".)
     The easiest way to get this is probably to look in a library's
     archive (probably on microfiche or CD-ROM) of the Wall Street
     Journal or the New York Times.  Don't forget about stock splits
     while doing the research. 
     In rare cases, the executor will choose to use an "alternate
     valuation date" instead of date of death.  The alternate valuation
     date, always 6 months after death, can be chosen only when it will
     reduce the estate tax, and if chosen, must be used for all property
     of the estate.  An executor who makes this election should notify
     the heirs of the value used. 
     Note that when figuring capital gains taxes, inherited property is
     always long term, per se.  In fact if you glance at Pub 550 it asks
     you to not use an acquisition date for inherited property but to
     write "INH" to indicate it is inherited property. 

Be careful of reinvested dividends! If a stock paid dividends and the
dividends were reinvested, computation of a fair cost basis requires a
bit of work.  All reinvested dividends need to be added to the cost
basis, otherwise the cost basis will be much too low and the person who
sells the security will pay too much tax.  If the dividend payment and
reinvestment records are not available, you need to reconstruct them. 
Find out from old Wall Street Journals or New York Times financial
sections how much the dividend was each year since the stock was
acquired or inherited, and use the number of shares and price per share
on the dividend pay date.  You might use a spreadsheet to show number of
shares each year, amount of dividend, price at time of reinvestment,
etc.  This requires a good deal of researching the dividend amounts and
the share price. 

If computing the cost basis of some security looks hopeless, here's an
alternative to consider: donate some or all the shares to charity.  If
you normally make donations to your church, alumni association, or other
charity, it is quite easy to persuade them to accept stock instead of
cash.  By doing so, you never have to calculate gains nor list the sale
as income on your tax return.  Moreover, if the stock was held more than
a year (long-term gain), you get to itemize the charitable deduction at
fair market value on the date of gift.  Note that stock gifted to
charity and held short term can be deducted at the lower of cost basis
or fair market value.  This implies that stock bought with reinvested
dividends within a year of the gift would be limited to the lower of
fair market value or cost basis. 

For the last word on the cost basis issue, see IRS Publication 551,
"Basis of Assets."

--------------------Check for updates------------------

Subject: Tax Code - Capital Gains Computation

Last-Revised: 4 Aug 1998
Contributed-By: John Schott (jschott at, Art Kamlet
(artkamlet at, Chris Lott ( contact me ), Rich Carreiro (rlcarr

Gains made on equities (i.e., stocks or mutual funds) are subject to
capital gains taxes.  In the simplest case, you bought a lot of shares
(either stocks or mutual funds) at some date, made no further
investments (took your dividends in cash), and finally sold the shares
at some later date.  Your gain is simply the difference between your net
cost and net income, and you report that as a capital gain.  This
article focuses on computing the amount of the gain (but not the amount
of tax you'll have to pay, see the article on capital gains tax rates
elsewhere in the FAQ for that). 

Note that this article discusses only realized capital gains.  Tax is
only due on a realized capital gain, never (at least not as of this
writing) on an unrealized capital gain.  A realized capital gain is
money in your pocket.  If you bought shares at 10 and sold at 20, you
realized a capital gain of $10 per share, and of course Uncle Sam (and
just about every other tax authority out there) wants a piece of the
action.  An unrealized capital gain is a gain that you have on paper; in
other words, you bought a stock at 10, still hold the shares, and on
some date it's trading at 20.  You have an unrealized capital gain as of
that date of $10 per share, and because it's unrealized, there are no
tax implications. 

The first part of computing capital gains and gains taxes is determining
the cost basis of the securities that you sold.  For more information on
that, see the FAQ article on computing cost basis .  That article
discusses how to compute the cost basis if you inherit or are given some
stock or other equities. 

Computing gains is simple for a sale of a single share, or a sale of a
single lot of shares.  The situation becomes more complex if you
acquired several lots of shares at different prices.  It's not so bad
for stocks, because when you sell shares of stock, you always, always,
always sell specific shares.  But when you sell shares in a mutual fund,
things are not as simple.  We'll cover these two cases next. 
   * Selling shares of stock. 
     For example, say you hold 200 shares of IBM, half of which you
     bought at $40 and half at $50 (I should be so lucky).  What price
     should you use if you sell 100 shares?
     In this simple example, it's your choice: either $40 or $50.  But,
     to be legal, you must specify to your broker precisely which lot
     you are selling before you give the sell order.  IRS Pub 550
     clearly says that adequate specific identification of shares has
     been made if you tell the broker at time of sale what shares are
     being sold and if the broker so notes it on the confirmation slip. 
     Many brokers (especially as they now have years of computer
     records) are able to mark that on your confirmation slip
     automatically.  But another way is to tell your broker and then get
     him to sign a confirmation letter attesting to that fact.  If you
     don't do this, the IRS, in an audit, may reverse your decisions. 
     Note that the broker is under no obligation to accept a specific
     shares order, but I personally would take my business to another
     broker if I ran into that. 
     In any case, the key element in identifying specific shares to be
     sold is that you've got to convince the IRS that you made your
     choice of what shares to sell prior to the trade and convince the
     IRS that you informed the broker of that choice (also prior to the
     If you don't tell the broker, and get no information on the
     confirmation slip, the specific shares you sell are the oldest
     (sometimes called first-in first-out or FIFO). 
   * Selling shares of a mutual fund. 
     Mutual fund investors have to choose one of four possible methods
     of computing their basis for sold shares.  These are as follows. 
       1. Specific shares -- the investor decides which specific shares
          are to be sold. 
       2. First-in-first-out (FIFO) -- the oldest shares are sold first
          (this is actually a kind of specific shares). 
       3. Average cost, single category -- the basis of a share is the
          average basis of all shares. 
       4. Average cost, double category (may now be triple category,
          given the new capital gains law) -- shares are segregated by
          holding period, the basis of a share in a given category is
          the average basis of all shares in that category. 
     Investors may switch between (1) or (2) as they like, but once (3)
     or (4) is chosen for a security, the investor must stick with that
     method until he has entirely liquidated his position in the
     security or receives IRS permission to change methods. 
     The following discussion details the average cost, single category
     method (3), which is probably the most commonly used method. 
     The description that "the basis of a share is the average basis of
     all shares" pretty much says it all.  Despite this, the calculation
     often confuses people, especially when additional purchases are
     made subsequent to sales, and it can be laborious to keep track of
     everything.  Key points to remember are the following. 
        * Reinvestment of distributions are treated exactly like (and in
          fact are) purchases. 
        * Every time a sale is made, the basis of every remaining share
          becomes the average cost used in the sale calculation.  A
          share has no "memory" of what its previous basis values were. 
        * For purposes of computing holding period only, you are deemed
          to be selling the oldest shares first.  You have no choice in
          the matter. 
     Various software packages such as Captool, by Captools Inc
     (formerly Techserve) can do the computation for you.  If I were
     doing it manually (or using a spreadsheet) I'd probably do
     something like the following. 
       1. Divide a piece of paper into six columns.  Label them "Date",
          "Number of shares", "Cost", "Total Shares", "Total Cost" and
          "Average Cost". 
       2. Fill in the first three columns for all your purchases up to
          the point of your first sale. 
       3. Now fill in the "Total Shares" column.  Obviously, for the
          first entry this will be equal to the number of shares bought. 
          For subsequent entries, it will be equal to the "Total Shares"
          value of the previous entry plus the "Number of Shares" value
          for the current entry. 
       4. Fill in the "Total Cost" column the same way. 
       5. Fill in the "Average Cost" value for the final entry by
          dividing that entry's "Total Cost" value by its "Total Shares"
          value.  You could do this for every entry (and that would be
          the easier thing to do in a spreadsheet) but only the average
          cost as it existed right before a sale matters, and if you're
          doing it manually why waste the time computing and writing
          down numbers you won't need?
       6. Now put in an entry for your first sale. 
             * Put down the date. 
             * Put the quantity of shares sold in the "Number of Shares"
               entry as a *negative* number (you are selling them, after
             * Multiply "Number of Shares" by the average cost you got
               in step (5) and enter that in the "Cost" column.  This
               will be negative -- as well it should -- since a sale
               reduces your total basis by the basis of the shares that
               are sold. 
             * Fill in "Total Shares" for this entry like you did in
               step (3).  Since "Number of Shares" for this entry is
               negative, "Total Shares" will decrease as it should. 
             * Fill in "Total Cost" for this entry like you did in step
               (4).  Since "Cost" for this entry is negative, "Total
               Cost" will decrease as it should. 
             * Note that your gain (or loss) on the sale is the sum of
               your sales proceeds and the "Cost" value (which is a
               negative number) of the sale entry. 
       7. If your next transaction is a sale, do it just like (6).  If
          your next transaction is a purchase:
             * Put down the date. 
             * Put down the shares bought in the "Number of Shares"
             * Put down the cost in the "Cost" column. 
             * Fill in "Total Shares" as in step (3). 
             * Fill in "Total Cost" as in step (4). 
             * If desired, fill in average cost column.  You only really
               have to do this for a purchase entry that immediately
               preceeds a sale entry. 
       8. Keep the sheet up to date with all purchases and sales as you
          make them. 
     Note that this procedure only tells you the overall gain or loss on
     a sale.  You still have to determine the holding period for the
     shares sold, and if multiple holding periods are involved,
     apportion the gain or loss into each holding period. 
     As previously stated, you must consider the oldest remaining shares
     to be the ones sold for this purpose.  So if you sell N shares, go
     back to your purchase records and mark off (physically or mentally)
     the oldest remaining N shares (which may well be from different
     purchases) and see what the holding periods are. 
     Here's an example for all of this:
        * On 02/01/97 buy 100sh for $1000. 
        * On 08/01/97 buy 75sh for $1000. 
        * On 12/23/97 reinvest $600 of distributions getting 40sh. 
        * On 12/01/98 sell 200sh for $4000. 
        * On 12/24/98 reinvest $300 of distributions getting 14sh
        * On 06/15/99 buy 100sh for $2000
        * On 10/31/99 sell 50sh for $900
     Date Nr Shares Cost Total Shares Total Cost AvgCost
     02/01/97 100 $1000.00 100 $1000.00
     08/08/97 75 $1000.00 175 $2000.00
     12/23/97 40 $ 600.00 215 $2600.00 $12.0930
     12/01/98 (200) ($2418.60) 15 $ 181.40
     12/24/98 14 $ 300.00 29 $ 481.40
     06/15/99 100 $2000.00 129 $2481.40 $19.2357
     10/31/99 (50) ($961.79) 79 $1519.61
     Since the basis of the shares sold on 12/01/98 was $2418.60 while
     the proceeds of that sale were $4000, there was a $1581.40 gain on
     the sale.  The shares that were sold were the 100 shares purchased
     02/01/97, the 75 shares purchased 08/08/97, and 25 of the forty
     shares purchased 12/23/97.  The 100 shares purchased 02/01/97 have
     a holding period of over 12 months, the 75 shares purchased
     08/08/97 also have a holding period of over 12 months, and the 25
     shares sold out of the block of 40 purchased 12/23/97 have a
     holding period of less than 12 months.  Enter each piece in the
     appropriate part of Schedule D, prorating the $2418.60 basis and
     the $4000 proceeds across the pieces based on the number of shares
     in each piece. 
     Now, since the basis of the shares sold on 10/31/99 was $961.79
     while the proceeds were $900, there was a $61.79 loss on that sale. 
     The shares that were sold were the remaining 15 shares in the block
     of forty purchased 12/23/97, the 14 shares purchased 12/24/98, and
     21 shares from the block of 100 purchased 6/15/99.  The 15 shares
     purchased 12/23/97 have a holding period over 12 months, while both
     the 14 shares purchased 12/24/98 and the 21 shares purchased
     06/15/99 have holding periods under 12 months.  Again, enter each
     piece in the appropriate parts of Schedule D, prorating the $961.79
     basis and the $900 proceeds. 
     Finally, there's a reporting shortcut.  If you have multiple
     purchase blocks in the same holding period category, you can
     combine them into a single entry.  Just write "various" for the
     acquisition date and combine the basis and proceeds of the blocks
     to get the basis and proceeds of the single entry.  For example,
     for the 10/31/99 sale, on the short-term part of Schedule D I would
     combine the 14 12/24/98 shares and the 21 6/15/99 shares into a
     single entry, reporting 35 shares, acquisition date of "various",
     sell date of 10/31/99, basis of $673.25, proceeds of $630.00, and a
     loss of $43.25. 
     And now you see why I use a piece of software to track all this and
     generate reports for me :-). 

Remember that the averaging method for computing cost basis applies only
to shares of mutual funds and does not apply to conventional stock
sales.  A cost basis includes brokerage and all other costs specifically
attributable to holding the security.  Be sure to correct your per-share
values for stock splits (see the article elsewhere in the FAQ for more
information about splits) and dividends, as well as any participation in
a DRIP. 

Ok, hopefully by now you have computed the total gain on your equity
sales.  Now you have to figure out how much tax you owe.  Please see the
article in the FAQ on capital gains tax rates for more help. 

--------------------Check for updates------------------

Subject: Tax Code - Capital Gains Tax Rates

Last-Revised: 10 Jan 2001
Contributed-By: Rich Carreiro (rlcarr at

While reading misc.invest.*, you may have seen people talking about
"long-term gains" or "short-term losses." Despite what it sounds like,
they are not talking about investment strategies, but rather a
potentially important part of the United States tax code.  All this
matters because the IRS taxes short- and long-term gains differently. 

The "holding period" is the amount of time you held some security before
you sold it.  For reasons explained later, the IRS cares about how long
you have held capital assets that you have sold.  The holding period is
measured in months.  The nominal start of the holding period clock is
the day after the trade date, not the settlement date.  (I say nominal
because there are various IRS rules that will change the holding period
in certain circumstances.) For example, if your trade date is March 18,
then you start counting the holding period on March 19.  On April 19
your holding period is one month.  On May 19 your holding period is two
months, and so on. 

With holding period defined, we can say that a short-term gain or
short-term loss is a gain or loss on a capital asset that had a holding
period of 12 months or less, and that a long-term gain or long-term loss
is a gain or loss on a capital asset that had a holding period of more
than 12 months. 

Note that a short-sale is considered short-term regardless of how long
the position is held open.  This actually makes a kind of sense, since
the only time you actually held the stock was between when you bought
the stock to cover the position and when you actually delivered that
stock to actually close the position out.  This length of time is
somewhere from minutes to a few days. 

Net capital gains and losses are fully part of adjusted gross income
(AGI), with the exception that if your net capital loss exceeds $3,000,
you can only take $3,000 of the loss in a tax year and must carry the
remainder forward.  If you die with carried-over losses, they are lost. 
Short-term and long-term loss carryovers retain their short or long-term
character when they are carried over. 

Discussions from this point on talk about the various tax rates on
capital gains.  It is important to note that these rates are only the
nominal rates.  Because capital gains are part of AGI, if your AGI is
such that you are subject to phaseouts and floors on your itemized
deductions, personal exemptions, and other deductions and credits, your
actual marginal tax rate on the gains will exceed the nominal tax rate. 

Short-term gains are taxed as ordinary income.  Therefore, the nominal
tax rate will be whatever tax bracket you are in. 

Long-term gains are a somewhat more complicated.  The majority of people
will only have two rates to worry about -- 10% and 20%.  Your long-term
gains are taxed at 10% if you are in the 15% bracket overall and 20% if
you are in any other bracket.  The long-term gains are included when
figuring out what bracket you're in.  However, the 10%/20% rate doesn't
apply to all long-term gains.  Long-term gains on collectibles, some
types of restricted stock, and certain other assets are instead subject
to rate that is the lesser of your tax bracket or 28%.  And certain
kinds of real estate depreciation recapture are taxed no higher than
25%.  I do note that for 1998 only, many average investors will see some
so-called 28% gain.  This will be from mutual fund capital gain
distributions made in the 1st quarter of 1998 for gains realized by the
fund in the closing months of 1997, when a different set of rules was in
place.  Your fund should provide explanations when you receive 1099-DIV
forms in early 1999. 

Another complication in long-term taxation arrives January 1, 2001.  As
of that day (unless Congress changes things before than), lower rates
come into effect for gains having a holding period of over 60 months
(called the "ultra-long-term rate" here).  The rates are 8% if you are
in the 15% bracket, 18% otherwise. 

If the asset was acquired before 1/1/2001 it can never gain 8%/18%
(i.e., ultra-long-term) status (with exceptions) no matter how long it
is held.  The exception is that you can mark the asset to market at its
fair market value on 1/1/2001.  You will have to declare as income and
pay tax on any unrealized gain (and presumably get to deduct any
unrealized loss) on the asset.  The holding period clock will also
reset.  (This is the same as selling and repurchasing the asset without
actually doing so.  It is currently unclear if wash sale rules will
apply to loss property marked to market). 

There is yet another twist to this exception -- if you are in the 15%
bracket, the 8% rate is available to you as of 1/1/01, even if you did
not acquire the asset before 1/1/01.  In any case, I strongly advise
researching the issue and talking to a tax professional before doing
something that is subject to this rule. 

Here's a summary table:

Tax Bracket S-T Rate L-T Rate U-L-T Rate
15% 15% 10% 8%
28% 28% 20% 18%
31% 31% 20% 18%
36% 36% 20% 18%
39.6% 39.6% 20% 18%

As you can see, the ordinary income and short-term rate is over 100%
higher (39.6% vs.  18%) than the ultra-long-term rate and close to 100%
higher than the long-term rate.  While you should never let the income
tax "tail" wag the prudent investing "dog," the ultra/long/short term
distinction is something to keep in mind if you are considering selling
at a gain and are getting close to one of the holding period boundaries,
especially if you are close to qualifying for long-term treatment. 

Now what happens if you have both short-term capital gains and losses,
as well as long-term gains and losses? Do short-term losses have to
offset short-term gains? Do long-term losses have to offset long-term
gains? Well, the rules for computing your net gain or loss are as

  1. You combine short-term loss and short-term gain to arrive at net
     short-term gain (loss).  This happens on Sched D, Part I. 
  2. You combine long-term loss and long-term gain to arrive at net
     long-term gain (loss).  This happens on Sched D, Part II. 
  3. You combine net short-term gain (loss) and net long-term gain
     (loss) to arrive at net gain (loss).  This happens on Sched D, Part
        * If you have both a short-term loss and a long-term loss, your
          net loss will have both short-term and long-term components. 
          This matters if you have a loss carryover (see below). 
        * If you have both a short-term gain and a long-term gain, your
          net gain will have both short-term and long-term components. 
          This matters because only the long-term piece gets the special
          capital gains tax rate treatment. 
        * If you have a gain in one category and a loss in another, but
          have a gain overall, that overall gain will be the same
          category as the category that had the gain.  If you have a
          loss overall, that overall loss will be the same category as
          the category that had the loss. 
  4. If you have a net loss and it is less than $3,000 ($1,500 if
     married filing separately) you get to take the whole loss against
     your other income.  If the loss is more than $3,000, you only get
     to take $3,000 of it against other income and must carry the rest
     forward to next year.  When taking the $3,000 loss, you must take
     it first from the ST portion (if any) of your loss.  The Capital
     Loss Carryover Worksheet in the Sched D instructions takes you
     through this. 
  5. If you have a net gain, the smaller of the net gain or the net
     long-term gain will get the special tax rate.  This happens on
     Sched D, Part IV. 

--------------------Check for updates------------------

Subject: Tax Code - Cashless Option Exercise

Last-Revised: 12 June 2000
Contributed-By: Art Kamlet (artkamlet at, Chris Lott ( contact
me )

This article discusses the tax treatment of an employee's income that
derives from stock options, specifically the case in which an employee
exercises non-qualified stock options without putting any money down. 

First, a digression.  What is a non-qualified option? A non-qualified
stock option is the most popular form of stock option given to
employees.  Basically, an employee who exercises a non-qualified option
to buy stock has to report taxable income at the time of the purchase,
and that income is taxed as regular income (not as a capital gain).  In
contrast, an incentive stock option (ISO) dodges these tax bullets, but
is more complicated because employees who receive ISOs have to worry
about alternative minimum tax (AMT).  Unfortunately some companies are
sloppy about naming, and use the term ISO for what are really
non-qualified stock options, so be cautious. 

Next, what is a cashless exercise? Basically, this is a way for an
employee to benefit from his or her stock option without needing to come
up with the money to purchase the shares.  Any employee stock option is
basically a call option with a very long expiration; hopefully it's also
deep in the money (also see the FAQ article on the basics of stock
options ).  When a call option is exercised, the person who exercises it
has to pay to buy the shares.  If, however, the person is primarily
interested in selling the shares again immediately, then a cashless
option becomes interesting.  The company essentially lends the person
the money needed for the option exercise for the fraction of a second
that the person owns the shares. 

In a typical cashless exercise of non-qualified stock options (you can
tell it is non-qualified because the W-2 form suddenly has a huge amount
added to it for stock option exercise), here is what happens.  Let's use
E as the Option Exercise Price and FMV as the fair market value of the
shares.  The employee needs to pay E as part of the option exercise. 
But this is a cashless exercise, so the company (or, more likely, a
broker acting as the company's agent) lends the employee that amount (E)
for a few moments.  The stock is immediately sold, for FMV.  The broker
takes back the amount, E, loaned to the employee for the exercise, and
pays out the difference, FMV-E.  The broker will almost certainly also
charge a commission. 

Ok, now for those fortunate people who are able to do a cashless stock
option exercise, and choose to do so, how do they report the transaction
to the IRS? The company imputes income to the employee of the difference
between fair market value and exercise price, FMV-E.  That amount is
added to the employee's W-2 form, and hopefully shows up in Box 14 with
a cryptic note such as STKOPT or whatever.  The amount FMV-E is the
imputed income.  Again, you will notice FMV-E is not only what the
broker paid out, it is also the imputed income amount that shows up in
the W-2 form. 

The Schedule D sales amount reported by the broker is FMV minus any
commission.  The employee's cost basis is the FMV.  So the FMV is the
sales price, and the Schedule D for this transaction will show zero (if
no commission was charged) or a small loss (due to the commission). 

In certain situations, FMV might differ slightly from the price at which
the shares were sold, depending on how the company does it, and if so,
the company should report the FMV to the employee.  Then the Schedule D
must be completed appropriately to show the short-term gain or loss (the
difference between the sales price and FMV). 

For extensive notes on stock and option compensation, visit the Fairmark
site with articles by Kaye Thomas:

Julia K.  O'Neill offers an extensive discussion of the differences
between incentive stock options and non-qualified options:

--------------------Check for updates------------------

Subject: Tax Code - Deductions for Investors

Last-Revised: 24 Oct 1997
Contributed-By: Art Kamlet (artkamlet at, David Ray

This article offers a brief overview of the deductions that investors
can claim when filing US tax returns. 

The most significant one is losses.  An investor may deduct up to
US$3,000 in net capital losses each year using the Form 1040 Schedule D. 
Additional losses in a calendar year can be carried forward to the
following year.  Note the key word in the first sentence: net capital
losses.  For example, if you realized $5,000 in capital gains and $9,000
in capital losses during a tax year, you would have a net capital loss
for that year of $4,000.  You could deduct $3,000 for that year, and
carry forward $1,000 of net loss to the following year's tax return. 
Another example: if you realized a loss of 4,000 in one stock and a net
gain of 4,000 in a second stock, you could not deduct anything because
the net loss was zero. 

What about margin interest? If you borrow money to purchase securities
(not tax-exempt instruments), and if you itemize deductions on Schedule
A, you can itemize as investment interest on Schedule A (Interest, not
Misc.  deductions) the investment interest you actually paid, but only
to the extent you had that much investment income.  Investment interest
that you cannot claim because you didn't have enough investment income
can be carried forward to the next year. 

Investment income includes investment interest, dividends, and
short-term capital gains.  You can elect to include mid- and long-term
capital gains, but if you do, you cannot choose to elect tax-favored
treatment of those gains. 

--------------------Check for updates------------------

aSubject: Tax Code - Estate and Gift Tax

Last-Revised: 6 Jan 2003
Contributed-By: Rich Carreiro (rlcarr at, Art
Kamlet (artkamlet at, John Fisher (TaxService at,
Chris Lott ( contact me )

This article offers an overview of the estate and gift taxes imposed in
the United States.  The main issue is the amount of money a person can
"gift" (used as a verb in this context) to another person without tax
consequences, as well as the tax consequences when that amount is
exceeded.  The handling of estates is relevant and discussed with gift
taxes because transfers while a person is living (i.e., gifts) can
influence estate taxes. 

Here's a brief summary.  An estate of less than US$1,000,000 will not be
taxed in 2003 (although it depends on prior gifts, read on).  A gift
recipient never has anything to worry about, no matter the size, because
gifts are not taxable income.  A gift giver who gives less than $11,000
to any one individual in one year also has nothing to worry about.  If a
person gives more than $11,000 to an individual in one year, then the
regulations discussed in the rest of this article must be followed
carefully.  Finally, note that gifts are never deductable from a gift
giver's gross income. 

A fundamental concept to understand here is the unified credit . 
Roughly speaking, this is the amount of wealth that the IRS (well,
really the US Congress) allows a person to transfer without incurring
various tax obligations.  As of this writing, the unified credit amount
for tax year 2003 is $1,000,000.  But given the annual gift tax
exclusion amount of $11,000 (newly increased in 2002 from 10,000 in
prior years), the total amount that a person can effectively transfer to
another individual without triggering taxes is much larger.  The term
"unified credit" is used because the credit is the "unified gift/estate
tax credit".  This is a single, combined credit amount that is applied
against both gift and estate tax. 

A person can gift fairly large amounts annually without affecting the
unified credit.  Basically, any US taxpayer can gift up to $11,000 to a
single person in a tax year and there are no tax consequences: the gift
giver's lifetime unified credit is not affected, and the gift recipient
pays no tax.  In fact, a person can make $11,000 gifts to as many
different people in a year as she or he likes with no tax consequences. 
(See below; this number is indexed to inflation and will change over
time.) Spouses can give each other gifts of any amount without gift tax
filings.  Finally, a husband and wife can gift anyone $22,000 without
gift tax consequences, but unless the husband gives 11,000 and the wife
gives 11,000 (e.g., they both write a check), they should file a Form
709a with the IRS and elect to use gift splitting. 

What is gift splitting? Gift splitting means a husband and wife can
elect to treat a gift given by one of them as if half were given by each
of them.  The implications are simple: If one spouse gives $22,000 to
someone during the year, and gift splitting is not elected, the IRS can
treat that as a 22,000 gift by just the one spouse, even if the funds
are drawn from a joint account.  The IRS Form 709a can be filed for
notifying the IRS that gift splitting is elected.  (The instructions for
the form are on the form itself.) This is a bit silly in many cases,
since in community property states, community property is automatically
considered split equally between each spouse, but that requires the IRS
to somehow know it came from community property funds and not from
non-community funds.  So they require you to prove it, basically. 

If a donor gives away more than $11,000 to a person (not a charity) in a
tax year, then the donor may owe gift tax, depending on the donor's
history of giving.  After making a large gift, the donor is responsible
for filing a Form 709 declaring that gift and keeping a running,
lifetime total of the lifetime exclusion used.  As long as the exclusion
is below the maximum, no gift tax is due.  Once the exclusion reaches
the maximum, the donor calculates the tax due with Form 709 and attaches
a check (payable to the United States Treasury).  So in a nutshell,
computation of gift tax is quite easy: just fill out the 709.  If there
is some remaining lifetime gift tax exclusion remaining, then there is
no tax due.  If there is no exclusion remaining, there is tax due.  Note
that there is no way to pay gift tax and somehow "preserve" some amount
of lifetime exclusion; the system simply does not work that way. 

Now we'll discuss the lifetime exclusion.  Basically, the first $1
million of transfers in life and death are exempt from estate and gift
tax as of 2002 (and remains that way in 2003).  However, it is not
handled in quite in the way that most people think.  Most people (for
example) think that when someone who made no taxable transfers during
life dies, you total up the estate, subtract off any deductions, and
then subtract $1,000,000 and compute the tax on whatever (if anything)
is left.  The way it actually works is that you subtract off any
deductions, compute the tax on that amount, and then apply against the
tax the unified credit of about $300,000 (this number needs to be

Of course the result is identical for most estates; the first $1 mil of
the estate is not taxed.  But look what happens to the first dollar past
the limit.  If the tax really was done the first way, the taxable estate
would be $1, and you'd be starting at the bottom of the estate tax
bracket structure.  But what actually happens is that you compute the
tax on an estate of $1,000,001, which leaves you in the middle of the
bracket structure, and then subtract off the credit.  So your marginal
rate is much higher under the way things actual work than it is under
the "naive" way. 

A gift (used as a noun) in this article means a gift of present value . 
A gift of present value is an unrestricted gift the receiver can use
immediately (if an adult, or immediately upon becoming an adult). 
However, if a trust is set up for a child and the trust is payable to
the child only on the child's 25th birthday provided the child has
graduated from college and has no felony convictions, that gift is
considered restricted (it's not a gift of present value), so a 709 would
have to be filed starting at the first gift dollar. 

Note that if securities or other non-cash instrument is given, the fair
market value of the securities on the gift date are used to determine
whether the gift tax rules apply. 

Ok, time for an example: If an individual makes a gift of present value
of $41,000 in a year, the 30,000 above the 11k limit reduces the amount
of estate excluded from estate tax to the current limit less the 30,000. 

Now another example: What happens if a wealthy married couple (we'll
call them Smith) gifts $44,000 to a less wealthy married couple (let's
call them Doe)? This is perfectly ok and has no tax consequences
provided things are done properly.  Let's examine some of the
possibilities.  If a single check is drawn on Mr.  Smith's account and
deposited into Mrs.  Doe's account, the very conservative amongst the
tax folk will point out that the gift was from Mr.  Smith and not Mr. 
and Mrs.  Smith and further, even if the check was to both Doe's, it was
deposited into only one of the Doe's accounts, so it could be a gift of
44,000 from one person to another! Since the gift splitting rule is out
there, the moderately conservative tax experts would have separate
checks written to Mr.  Doe and Mrs.  Doe.  The ultra conservative would
have four checks written of 11k each (the combinations are left as an
excercise for the reader :-).  The use of four checks avoids the gift
splitting election as well as the worry about whose account it is
deposited in.  (Since a spouse can gift unlimited amounts to the other
spouse, it really should not matter.)

Dramatic changes to the estate tax laws were made by the Economic Growth
and Tax Relief Reconciliation Act of 2001.  In fact, that act repealed
the estate tax -- but with many caveats.  The lifetime exclusion numbers
for the next ten years are as follows: $1 million in 2003; 1.5 million
in 2004 and '05, $2 million for 2006, '07, and '08, and finally $3.5
million in 2009.  And in 2010, the estate tax is gone.  But (don't you
just love Congress), in 2011 the estate tax comes back with a lifetime
exclusion of $1 million.  This is how Congress balances its books.  It's
anyone's guess what will actually happen by 2011.  Note that the gift
tax was not repealed; the lifetime exclusion remains stuck at $1 million
after 2011.  And the annual gift tax exclusion amount is $11,000 in
2003; because this number is indexed to inflation, it is difficult to
predict how this value will change in future years. 

To recap one important issue, the blessed repicients of a gift never pay
any tax.  Stated a bit differently, receipt of a gift is not a taxable
event.  Of course if someone gives you securities, and you immediately
sell them, the sale is a taxable event.  See the article elsewhere in
the FAQ about calculating cost basis for help with computing the number
used when reporting the sale to the IRS. 

For more information about estate issues, visit Robert Clofine's site:

--------------------Check for updates------------------

Subject: Tax Code - Gifts of Stock

Last-Revised: 20 Dec 1999
Contributed-By: Art Kamlet (artkamlet at, Chris Lott ( contact
me )

This article introduces some issues that crop up when making gifts of
stock.  Gift taxes are an orthogonal but closely related issue; see the
article elsewhere in the FAQ for more details.  Also see the FAQ article
on determining the cost basis of securities for notes on computing the
basis on shares that were received as a gift. 

Occasionally the question crops up from a person who has nice stock
gains and would like to give some money to another person.  Should the
stockholder sell stock and give cash, or give stock directly? It's best
to seek professional tax advice in this situation.  If stock is given,
and the recipient needs cash so sells the shares immediately, the
recipient only keeps about 80% of the value after paying capital gains
tax.  I.e., the gift came with a big tax bill.  On the other hand, if
the stockholder sells some stock (perhaps to stay under the 10k annual
exclusion), that pushes up that person's annual income.  If the
stockholder has a sufficiently high income, then the stock sale could
push that person across various thresholds, one for which itemized
deductions begin to be reduced, and the other where personal exemptions
begin to be phased out.  In addition, higher income could possibly
trigger alternate minimum tax (AMT). 

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

User Contributions:

Gerri Pisciotta
My employer accidentally advised the company handling the 401k investment that I had been terminated, when in fact I had not. As a result, withdrawals discontinued from my pay and I missed a couple years of contributions. Since I never withdrew from the plan, is my employer liable for making up these contributions? If I made a lump sum catchup contribution,could they do the same?
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Truly lots of awesome tips!
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