Understanding the Tax Basis of Your Investments: A Guide for Donaldson Employees

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What Is The Tax Basis of Your Investments?

The tax basis of your investment is the base figure you use when determining whether you have recognized capital gain or loss on the sale of an investment. (Gain or loss on the sale of your investments equals the difference between your adjusted tax basis and the amount you realize upon the sale of the investment.) In many cases, your taxable gain or loss will equal the difference between what you initially paid for the investment and the sale price. In other words, your adjusted tax basis often equals your cost. However, it's important for our Donaldson clients to keep in mind that in many circumstances, your adjusted tax basis will not equal the cost of the investment.

Determining Tax Basis When You Acquire Your Investment

When you acquire an investment, your initial tax basis is normally your cost. However, if you did not purchase your investment (for example, if you received the investment as a gift, as an inheritance, or in a tax-free distribution), then your initial tax basis will be based on a figure other than cost. Details about these acquisitions will be discussed later for Donaldson employees.

Adjusting Tax Basis When You Own Your Investment

We'd like to remind our clients from Donaldson clients that in some cases, you will need to increase or decrease the initial tax basis of your investment. For example, if your investment produces depreciation deductions, these deductions reduce your tax basis in the investment. However, if you make additional investments or improve your investment property, you may be able to increase your tax basis in the property. Basis adjustments may also be necessary for our Donaldson clients whose investments are divided or consolidated into a different number of units or shares.

Determining Tax Basis When You Sell Your Investment

You may sell less than all of your shares in an investment. For our Donaldson clients who purchased these shares at different times and prices, you may have different tax bases for different shares. There are three different methods for determining tax basis of the shares sold in this case: (1) specific identification, (2) first in, first out (FIFO), or (3) average cost.

How Do You Determine Tax Basis When You Acquire Your Investment?

Your initial tax basis in an asset will depend on how you acquired the asset. Depending on the method of acquisition, your initial tax basis may be equal to your cost, the basis of the transferor in the asset, the fair market value (FMV) of the asset at the time of acquisition, or the basis of property you exchanged to acquire the asset.

Cost Basis

If an asset has a cost basis, this means that the initial tax basis of the asset equals the amount you paid for the asset. Thus, if you purchase shares of stock for $10,000, then your initial tax basis in those shares will be $10,000.

Transferred Basis

If an asset has a transferred basis this means that your initial tax basis in the asset will be the tax basis of the person who transferred the asset to you. There are two situations where this is likely to occur: with gifts and with certain partnership transactions. When you receive a gift, the gift is not included in your gross income. However, you take the donor's basis in the property.

The basis is increased by any gift tax paid that is attributable to appreciation in value of the gift (appreciation is equal to the excess of fair market value over the donor's basis in the gift immediately before the gift), but the total basis cannot exceed the fair market value of the property at the time of the gift. This is for the purpose of determining gain. (You cannot use this basis for the purpose of determining a loss.)

Example(s):  Say your father gives you X stock worth $1,000. He purchased the stock for $500. Assume the gift incurs no gift tax.  Your basis in the stock, for the purpose of determining gain on the sale of the stock, is $500.

Example(s):  Now assume that the stock is only worth $200 at the time of the gift and you sell it after receiving it. You do not pay tax on the sale of the stock. You do not recognize a loss either. In this case, your father should have sold the stock (and recognized the loss) and then transferred the sales proceeds to you as a gift. (You are not permitted to transfer losses.)

In a tax-free distribution of an asset from a partnership to a partner, the partner takes the partnership's basis in the asset.

Example(s):  Assume your partnership distributes a building to you worth $100,000. The building was purchased for $80,000. The partnership took $30,000 of depreciation deductions on the building. What is your basis in the building? It equals the partnership's basis before the distribution, which was $50,000 ($80,000 less $30,000). If you sold the building immediately after the distribution, you would have a $50,000 gain ($30,000 of this gain would likely be recaptured as ordinary income).

Fair Market Value (FMV) Basis

You generally receive an initial basis in an asset equal to the asset's FMV in two situations. The first situation we'd like to go over with our clients from Donaldson is when you receive the asset via inheritance. The FMV is established on the date of death or on an alternate valuation date six months after death. The second situation we'd like to discuss with our Donaldson clients is where you would receive an initial basis in an asset equal to FMV when the value of the consideration paid for the investment is not readily determinable.

(This is not a factor with assets acquired in exchange for marketable securities.) For example, if you trade one tangible investment asset for another in an arm's-length transaction, there is an assumption that the values of the assets exchanged are equal. Therefore, assuming that the exchange is not a tax-free transaction, you need to determine the FMV of the transferred property in order to determine your gain or loss on the transferred property and the tax basis of the new property.

Exchanged Basis

An exchanged basis means that you determine your basis in new property from property previously owned by you. This occurs with property acquired in a tax-free transaction.

Example(s):  Assume you contribute land to a business in a tax-free transaction in which you receive one share of stock. The land and the stock are both worth $1,000. Your basis in the land was $500. Therefore, your basis in the stock is also $500. This is an exchanged basis. This often occurs in tax-free business formations. It also occurs when you exchange like-kind property in a tax-free transaction.

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Tip:  We'd like these Donaldson employees to note that in the above example the business's basis in the land is also $500 (this is a transferred basis).

How Do You Adjust Tax Basis?

It's important that these Donaldson clients keep in mind that you may be required to increase or decrease your tax basis under certain circumstances. In particular, this may happen if you take certain deductions with respect to your investment, you reinvest or improve the investment, or receive investment units in a stock split or consolidation.

How Depreciation Impacts Your Tax Basis

Investments in tangible property (such as buildings) are often depreciable. This means that you get a deduction against your current ordinary income for the estimated wear and tear on the asset. These deductions reduce your tax basis.

Example(s):  Assume you invest in a machine for $100,000 and that you are permitted a deduction for depreciation equal to   $20,000 per year for five years. You sell the investment for $40,000 in year six. You took a total of $100,000 in deductions on this   asset. What is your basis in the year of the sale? It is your cost basis adjusted for deductions--in this case, $100,000 less   $100,000. Thus, your basis equals zero, and your gain is $40,000.

How Reinvestment Impacts Your Tax Basis

In certain cases, you may reinvest your earnings. If taxable earnings are reinvested without a change in your investment shares or investment units, then your basis in those shares or units increases. Likewise, you may make capital improvements to land, buildings, or tangible property or to a business you own. These contributions of capital increase your tax basis in the investment.

How Splits, Stock Dividends, Stock Rights, or Consolidations Impact Your Tax Basis

A stock split involves a division of your stock into more units of the same stock. In theory, the aggregate value of the old and new shares should be the same.

Example(s):  Assume Corporation X declares a 2-for-1 stock split. You own 100 shares that you purchased two years ago at $5 per share and are currently worth $10 per share (or $1,000) before the split. After the stock split, you own 200 shares. These are worth $5 per share (or $1,000). There is no gain on receipt of the additional shares.  A stock dividend is a proportionate distribution of stock to all the shareholders. Similar to a stock split, it essentially subdivides the stock.

Example(s):  Assume Corporation X declares a proportionate 10 percent stock dividend. You own 100 shares that you purchased two years ago at $5 per share and are currently worth $10 per share (or $1,000) before the split. After the stock split, you own 110 shares. These are worth approximately $9.09 per share (or $1,000). There is no gain on the distribution.

Your gain (or loss) on a subsequent sale is the difference between your cost basis and the sale price. How do you determine the basis on your shares? You allocate the basis of the old stock proportionally between your original shares and the shares received in the stock dividend or stock split. For any Donaldson employees who purchased several blocks of stock at different times, you must allocate the basis proportionally.

In the preceding scenario, the $500 basis is allocated among the 200 shares. Thus, the basis per share is $2.50. In the second example, the $500 basis is allocated among the 110 shares. Thus, the basis per share is approximately $4.55 per share.

The holding period in stock received from a stock split or a stock dividend is the same as the holding period for the original shares. For our clients from Donaldson who purchased several blocks of stock at different times, you must allocate the holding period proportionally. In the preceding examples, the holding period is two years for all the stock.

From time to time, a corporation may distribute rights to purchase its stock to its shareholders. If the value of stock rights distributed to you in a tax-free transaction exceeds 15 percent of the value of your stock, then you must allocate the basis in your stock between the stock and the rights based on their relative FMVs on the date of distribution. If the value of the stock rights is less than 15 percent, you may elect to allocate the basis proportionally based on value or treat the basis in the distributed rights as zero. You may wish to make the allocation when you expect to sell the rights but not the stock. You may prefer a zero basis in the rights when you expect to sell the stock but not the rights.

How Do You Determine Tax Basis When You Sell Your Investment?

There are occasions when you might sell only part of your holdings in an investment in securities.

Example(s):  Assume you own 100 shares of X stock. You acquired the stock by purchasing 10 shares per year for 10 years. The purchase price for each block of shares differed. You decide to sell 50 shares. What is the tax basis of these shares?

For most investments, the IRS permits you to use one of the following methods:

• Specific identification method
• FIFO method
• Average cost method

Specific Identification Method

The specific identification method lets you pick and choose which securities you sell. Of course, the advantage to this is that you can pick the securities, the sale of which will result in the smallest tax liability. It's important that our Donaldson clients are aware that this may involve the selection of securities with a high tax basis and/or built-in-losses. It also may result in the sale of securities with longer holding periods or may even include a selection of securities which will produce short-term gain when adequate losses are available to offset such gain.

To use the specific identification method, you must be able to adequately identify the securities being sold. You are likely to hold your investments in one of two forms: in your broker's name or in your name.

• Securities held in your broker's name--Most people hold securities in their investment accounts. For practical reasons, the securities are generally not registered in your name but are registered in the broker's name and credited to your account. An adequate identification is made if, at the time of the sale, you specifically identify which shares you want your broker to sell. You need to get a written confirmation from your broker regarding your selection. These Donaldson employees should also identify the stock by the purchase date and price.
• Securities held in your name--The securities sold are the securities that are delivered or transferred. This is true even if you instructed your broker to sell from a different lot. In some cases, you will sell fewer shares than are represented by the stock certificate.

Example(s):  Assume you sell 50 shares but have only a 100-share certificate. The certificate will be transferred, and you are   credited with the remaining odd lot. If you purchased the 100 shares at different times and prices, you can specify which shares   you wish to sell. As long as you identify these shares by purchase date and price and you get a written confirmation, you have   satisfied the adequate identification requirement. This is true even though the actual certificate representing all 100 shares is   transferred.

Tip:  The specific identification method is applicable to all of your marketable investments.

First In, First Out (FIFO) Method

The FIFO method requires you to treat the first share purchased as the first sold. This is beneficial from a long-term capital gain distinction, but it may have negative consequences in terms of tax basis if the market value of the securities has increased over time.

Tip:  The FIFO method is applicable to all of your marketable investments (such as stocks, bonds, and mutual funds), and is the rule which generally applies when the specific identification method is not applicable.

Average Cost Method

When you sell shares in an open-end mutual fund, you are entitled to use the average cost method to determine the basis of the shares sold. If you use the average cost method, you have two options.

The first option for our Donaldson clients using the average cost method is referred to as the average-cost single category method. This allows you to average the basis of all mutual fund shares regardless of how long you have owned the shares. The actual holding period is determined under the FIFO method. Thus, where shares are increasing in value, you are likely to get a more favorable tax basis as well as a longer holding period.

The second option for our Donaldson clients who are using the average cost method is called the average-cost double category method. This requires you to calculate separate average cost bases for long- and short-term capital gain shares. You may then choose which shares you wish to sell. This provides you with greater flexibility in selecting your tax treatment.

To take advantage of the average cost methods, you must make an election on your tax return. Once this election is made, you are not permitted to switch to another method without approval from the IRS. In addition, if you use the double category method, you must also inform the mutual fund custodian whether the shares sold are treated as long or short-term.