Taxes Made Simple

When you sell something (such as a share of stock) for more than you paid for it, you’re generally going to be taxed on the increase in value. This increase in value is known as a “capital gain.”

The amount of gain is calculated as the proceeds received from the sale, minus your “adjusted cost basis.”

What on Earth Does “Adjusted Cost Basis” Mean?

In most cases, your adjusted cost basis in an asset is simply the amount that you paid for that asset. (Note: This includes any brokerage fees that you paid on the transaction.)

EXAMPLE: Lauren buys a share of Google® stock for $250, including brokerage fees. She owns it for two years and then sells it for $400. Her adjusted cost basis is the amount she paid for it: $250. Her gain will be calculated as follows:

$400 (proceeds from sale)
- $250 (adjusted cost basis)
= $150 (capital gain)

Long Term Capital Gains vs. Short Term Capital Gains

The rate of tax charged on a capital gain depends upon whether it was a long term capital gain (LTCG) or a short term capital gain (STCG). If the asset in question was held for one year or less, it’s a short term capital gain. If the asset was held for greater than one year, it’s a long term capital gain.

STCGs are taxed at normal income tax rates. LTCGs, however, are taxed at a maximum of 15%. So if you’re ever considering selling an investment that’s increased in value, it might be a good idea to think about holding the asset long enough for the capital gain to be considered long term.

Note that a capital gain occurs only when the asset is sold. This is important because it means that fluctuations in the value of the asset don’t constitute a taxable event.

EXAMPLE: Beth buys ten shares of Honda Motor Company® at $25 each. Five years later, Beth still owns the shares, and the price per share has risen to $45. Over the five years, Beth isn’t required to pay any tax on the increase in value. She will only have to pay a tax on the LTCG if/when she chooses to sell the shares.

Why Taxation of Mutual Funds Is So Very Strange

Mutual funds are taxed in a way that sets them apart from other investments.

Drastically simplified version:

In essence, mutual funds shareholders are taxed every year based upon the changes in the values of the funds that they own. Note how this is unlike other investments, which are taxed only when the asset is sold.

More precise (longer) version:

Mutual funds are collections of a very large quantity of other investments. For instance, a mutual fund may own thousands of different stocks as well as any number of other investments like bonds or CDs.

Each year, a mutual fund (like any other investor) is responsible for paying taxes on the net capital gains it incurred over the course of the year. However, instead of the mutual fund paying those taxes itself, each of the fund’s shareholders pays her share of the related taxes.

What makes the situation particularly odd is that, in any given year, the capital gains realized by the fund can vary (sometimes significantly) from the actual change in value of the shares of the fund.

EXAMPLE: Deborah buys a share of Mutual Fund XYZ on January 1 for $100. By the end of the year, the investments that the fund owns have (on average) decreased in value, and Deborah’s share of the mutual fund is now worth $95.

However, during the course of the year, the mutual fund sold only one stock from the portfolio. That stock was sold for a short term capital gain. Deborah is going to be responsible for paying tax on her share of the capital gain, despite the fact that her share in the mutual fund has decreased in value.

Note how even in years when the value decreases, it’s possible that the investors will be responsible for paying taxes on a gain. Of course, the opposite is also true. There can be years when the fund increases in value, but the stock sales made by the fund result in a capital loss. And thus the investors have an increase in the value of their holdings, but they don’t have to pay any taxes for the time being.

Capital Gains from Selling Your Home

Selling a home that you’ve owned for many years can result in an absolutely enormous long term capital gain. Good news: It’s very likely that you can exclude (that is, not pay tax on) a large portion—or even all—of that gain.

If you meet three requirements, you’re allowed to exclude up to $250,000 of gain ($500,000 for married couples filing jointly). The three requirements are as follows:

1. For the two years prior to the date of sale, you did not exclude gain from the sale of another home.
2. During the five years prior to the date of sale, you owned the home for at least two years.
3. During the five years prior to the date of sale, you lived in the home as your main home for at least two years.

Note: To meet the second and third requirements, the two-year time periods do not necessarily have to be made up of 24 consecutive months.

EXAMPLE: Jason purchased a home on January 1, 2003. He lived there until May 1, 2004 (16 months). He then moved to another city (without selling his original home) and lived there until January 1, 2005. On January 1, 2005 Jason moved back into his original home and lived there until September 1, 2005 (8 months) when he sold the house for a $200,000 gain.

Jason can exclude the gain because he meets all three requirements. The fact that his 24 months using the home as his main home were not consecutive does not prevent him from excluding the gain.

Capital Losses

Of course, things don’t always go exactly as planned. When you sell something for less than you paid for it, you incur what is known as a capital loss. Like capital gains, capital losses are characterized as either short term or long term, based upon whether the holding period of the asset was greater than or less than one year.

Each year, you add up all of your short term capital losses, and deduct them from your short term capital gains. Then you add up all of your long term capital losses and deduct them from your long term capital gains. If the end result is a positive LTCG and a positive STCG, the LTCG will be taxed at a maximum rate of 15%, and the STCG will be taxed at ordinary income tax rates. If the end result is a net capital loss, you can deduct up to $3,000 of it from your ordinary income. The remainder of the capital loss can be carried forward to deduct in future years.


EXAMPLE 1: For 2007, Aaron has:
$5,000 in short term capital gains,
$4,000 in long term capital gains,
$3,000 in short term capital losses, and
$2,500 in long term capital losses.

For the year, Aaron will have a net STCG of $2,000 ($5,000-$3,000) and a net LTCG of $1,500 ($4,000-$2,500). His STCG will be taxed at his ordinary income tax rate, and his LTCG will be taxed at 15%.


EXAMPLE 2: For 2007, Seth has:
$2,000 in short term capital gains,
$3,000 in long term capital gains,
$3,500 in short term capital losses, and
$5,000 in long term capital losses.

Seth has a net short term capital loss of $1,500 and a net long term capital loss of $2,000. So his total capital loss is $3,500. For this capital loss, he can take a $3,000 deduction against his other income, and he can use the remaining $500 to offset his capital gains next year.

So what happens when you have a net gain in the short term category and a net loss in the long term category, or vice versa? In short, what happens is that the net short term capital gain (or loss) gets combined with the net long term capital gain (or loss).

EXAMPLE 1: For 2007, Kyle has:
$5,000 net short term capital gain and
$4,000 net long term capital loss.

Kyle will subtract his LTCL from his STCG, leaving him with a STCG of $1,000. This will be taxed according to his ordinary income tax bracket.


EXAMPLE 2: For 2007, Christopher has:
$3,000 net short term capital loss and
$6,000 net long term capital gain.

Christopher will subtract his STCL from his LTCG, leaving him with a LTCG of $3,000. This will be taxed at a maximum of 15%.


EXAMPLE 3: For 2007, Jeremy has:
$2,000 net short term capital gain and
$3,000 net long term capital loss.

Jeremy will subtract his LTCL from his STCG, leaving him with a $1,000 LTCL. Because this is below the $3,000 threshold, he can deduct the entire $1,000 loss from his ordinary income.

EXAMPLE 4: For 2007, Jessi has:
$2,000 net long term capital gain and
$4,000 net short term capital loss.

Jessi will subtract her STCL from her LTCG, leaving her with a $2,000 STCL. Because this is below the $3,000 threshold, she can deduct the entire $2,000 loss from her ordinary income.

Simple Summary

• If an asset is held for one year or less, then sold for a gain, the Short Term Capital Gain will be taxed at ordinary income tax rates.
• If an asset is held for more than one year, then sold for a gain, the Long Term Capital Gain will be taxed at a maximum rate of 15%.
• If you have a net Capital Loss for the year, you can subtract up to $3,000 of that loss from your ordinary income. The remainder of the loss can be carried forward to offset income in future years.
• Mutual fund shareholders have to pay taxes each year as a result of the net gains incurred by the fund. This is unique in that taxes have to be paid before the asset is sold.
• If you sell your home for a gain, and you meet certain requirements, you may be eligible to exclude up to $250,000 of the gain ($500,000 if married filing jointly).

For More Information, Take a Look at My Related Book.

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A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!" Aaron Torres

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