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Leslie Bonacum
Neil Allen

Markets Improving, but CCH Finds Investors Eager to Realize Gains in 2003 Need to Watch Tax Implications

New Tax Laws, Complicated Cost Basis Calculations Increase Schedule D Challenges

(RIVERWOODS, ILL., December 4, 2003) - While investors may have started this year still recovering from a treacherous stock market ride, many are set to end 2003 with portfolios that could be far healthier than they’ve seen in some time. Combining both a rebounding market with another round of tax law changes, investors have additional tax complexities to consider as they evaluate their year-end portfolios, according to CCH INCORPORATED, a leading provider of tax law information and software.

"Investment decisions need to be driven by each individual’s investment goals, but once those goals are identified, factoring in different tax implications can make a significant difference in helping you keep more of what your investments make," said Cameron Routh, vice president of partner relations for CCH GainsKeeper (, a leading provider of automated tax-based financial tools and services for the investment community.

Following are some of the tax considerations and tax strategies that investors may want to keep in mind as they review their portfolios before year end.

Gaming for Long-term Capital Gains

As of May 6, 2003 (through 2008) the long-term capital gains rate has been reduced to 15 percent for taxpayers in the 25-percent and higher tax brackets and to 5 percent for those in the 10- and 15-percent brackets. If these gains were realized before May 6, 2003, they are subject to the old rates of 20 percent for those in the 25-percent and above tax brackets and 10 percent for those in the 10- and 15-percent tax brackets.

The long-term capital gains rate only applies to investments held for more than 12 months; investments held less than this are short-term - and taxed at your regular income tax rate. Lastly, the amount of capital losses that can be taken annually against ordinary income remains $3,000.

Knowing all this is one part of investment tax planning. Using this knowledge effectively is what makes the difference.

For example, an investor in the 33-percent tax bracket trying to decide whether to sell 100 shares in a Stock A that she purchased nine months ago or 100 shares of Stock B she purchased two years ago, when both are going to generate a gain of $5,000 would find the amount she actually keeps is quite different depending on which she sells. Selling Stock A would result in a short-term gain, taxed at her 33-percent ordinary income level, for a total tax of $1,650; while selling Stock B would create a long-term gain taxed at the capital gain rate of just 15 percent - for a total tax of just $750.

"The higher your income, the greater the spread is between your ordinary tax bracket and the capital gains tax rate. This makes gaming to realize long-term, rather than short-term, gains all the more valuable," said Routh.

Routh added that it’s important to keep track of how each corporate action changes the cost basis.

"Many people assume that the purchase price is the cost basis, but each merger, split and other corporate action changes the basis. If you don’t track these you could significantly overstate a gain, costing you more in taxes, or understate your gain leaving you liable for back taxes, interest and other penalties," Routh said.

Harvesting for Losses

Given the rapid climb and subsequent fall of the stock market over the last few years, many individuals likely have a few holdings in their portfolios that are close to worthless. From a tax standpoint, selling these holdings can generate losses, which can help offset gains to further reduce your tax costs.

For example, an investor who purchased a stock at $100 per share in 1999, which is now trading at just $2 per share, could realize close to $10,000 in long-term losses. This loss could be written off against up to the same amount in capital gains from other investments sold during the year or up to $3,000 in ordinary income. Any amount that could not be realized as a loss in 2003 can be carried forward to write off against gains or ordinary income in future years.

"This is one of the most effective ways to harvest losses and one of the hardest because it requires investors to swallow their pride and sell at a loss," said Routh. "But investors also are taxpayers, and they have to remember that at tax time, losses aren’t a bad thing."

Designating Investment Sell Methodologies

Another tax-advantaged strategy is to use the specific ID method to identify the tax-lots most advantageous to sell, rather than simply defaulting to the IRS’ first in first out (FIFO) method for stocks and mutual funds, which often is not the most efficient option for taxpayers.

Suppose, for example, that you are in the 25-percent tax bracket. In December 2001 you invested $10,000 in shares of QRS Company; your adjusted cost-basis for those shares is $25 per share. In August 2002, you purchased $5,000 more shares; now with an adjusted cost basis of $50 per share. In December 2003, with the share price now at $55, you decide you want to sell 100 shares.

If FIFO is used, it would conclude that you had sold 100 of the first shares you’d bought. Your cost basis was $25 a share and you sold 100 shares for $55 each, realizing a $3,000 gain ($55 less $25 times 100).

Because you held the investment for longer than 12 months, it’s taxed at the 15-percent long-term capital gains rates if you’re in the 25-percent income tax bracket, meaning your tax on the $3,000 is $450. However, if you had indicated to sell 100 shares from the tax-lot you purchased in August 2002 with a basis of $50 per share, you would only have realized a gain of $5 per share for a total capital gain tax of just $75 ($55 less $50 times 100) versus $450.

Unless they notify their fund company prior to selling shares, mutual fund investors must also use the FIFO method. Often they choose the average cost method, which uses a single average price for all the shares held; or the double category method, which splits shares into long-term and short-term groups and then uses the average cost for whichever group is designated to be sold.

By definition, average cost is a poor method for tax efficiency as it fails to identify individual tax lots that would maximize or minimize tax consequences. By using Specific ID an investor has greater control over tax liabilities and after-tax performance.

Caution with DRIPS to Avoid Wash Sales

A "DRIP" is a dividend reinvestment plan and a "wash sale" describes trading activity in which you sell shares of a security at a loss and within 30 days - either before or after that sale - you purchase a substantially identical security.

Even someone who is aware of the wash sales rule may inadvertently find they’ve violated the rule due to an automatic DRIP.

"Automatic reinvesting is a great way to save," said Routh, "But it can end up being costly if investors aren’t aware of what changes are being made and the ramifications this has on their portfolios," said Routh.

With a wash sale, your loss is deferred for tax purposes, and you need to offset the deferred loss with a wash sale cost adjustment on the newly acquired tax lot.

For example, say you sold 200 shares of DEF Company for a total of $4,000 on November 18, 2003. Your cost basis - what you purchased the stock for plus any corporate actions - was $4,400, so you have a loss of $400. On December 15, your DRIP automatically purchases 100 new shares at $25 per share. Because the repurchase happened within 30 days of the initial sale, you have a wash sale situation, meaning that you can’t immediately realize the $400 loss from the original sale.

Instead, you have to adjust the cost basis for the 100 new shares to include the $400 loss. So the adjusted basis for the new 100 shares is the purchase price of $2,500 for the 100 new shares plus $400 for the wash sale, or $2,900.

"For taxpayers who are counting on losses to offset gains, wash sales can be very damaging as they may end up owing a lot more in taxes than planned," said Routh. "With more companies paying dividends and investors trying to balance cashing in on possible gains while off-setting them with losses, knowing true cost basis and which shares of an investment to sell can really make a difference in whether or not they realize tax savings."


CCH INCORPORATED, a Wolters Kluwer company, was founded in 1913, and has served four generations of business professionals and their clients. CCH GainsKeeper (, based in Quincy, Mass., is the leading provider of automated tax-based financial tools and services for the investment community and is a division of CCH.

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