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Tax Q&A: “What is my tax liability when I sell stock?”

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Tax Q&A: “What is my tax liability when I sell stock?”

This depends on how much you made, and how long you held it.

To calculate the first, find out how much you paid for the stock, and how much you sold it for (be sure to account for stock splits, but not for dividends, warrants, and spinoffs). For example, if you bought 100 shares at $25 and sold them at $30, your capital gain is 100 * (30 – 25), or $500.

Next, you’ll need to calculate your holding period. Your holding period is basically how long you’ve owned the stock, but the calculation is a little strange. First, you’ll start on the day after; you made the trade: if you bought on September 15, your holding period begins on the 16th. Second, your holding period is calculate based on the day of the month, not the number of days — so a holding period is one month if you hold from the 15th to the 15th, whether that’s in February or October. For tax purposes, your gain is calculate as ‘short-term’ if it’s under twelve months (i.e. you sell on or before the date of your initial purchase), and long-term otherwise.

Short-term capital gains are taxed at the same level as regular income. Long-term capital gains are taxed at a lower rate — 15% if your income tax bracket is 25% or more, and 0% otherwise. (Of course, the very low levels of stock ownership among the bottom tax brackets make this mostly a cosmetic choice).

That’s probably all you need to know, but what if your situation is more complicated? There are a few other issues to cover. First, dividends are not taxed as capital gains — they are, however, taxed at the same 15% rate. Spinoffs — a situation in which shareholders in one company get shares of a subsidiary (for example, in 1999 Hewlett Packard gave shareholders ownership of Agilent Technologies, their scientific instruments division), will reduce your tax basis by the value of the spinoff. To take the previous example, if you owned 100 shares of a stock worth $25, and then received 100 spun-off shares worth $10 each, your tax basis would drop from $2500 (100 * $25) to $1500 ($2500- ($100 * 10)). Sounds like a bad deal, but this puts your spinoff stock’s tax basis at $1000, rather than $0 (even though you didn’t have to buy the spun-off stock), so if you sell immediately, you won’t face any tax consequences. On a side note, many investment advisors have done well purchasing spinoff stocks — often, investors are simply not interested in getting to know a whole new company, so they sell and drive down the price.

A much more complicated problem is a warrant issue. In a warrant issue, a company grants shareholders the right to buy more shares of the same company. Companies issue warrants for a variety of reasons, including the desire to raise money while splitting the stock (if a stock is trading at $25, and the company issues warrants allowing each shareholder to buy one share for each share already owned at $20 per share, the company will raise cash equal to the number of shares outstanding multiplied by twenty, and will double the number of shares at the same time).

The tax treatment of warrants depends on a fairly arbitrary rule: if the warrant’s fair market value on the day of the issue, the investor’s cost basis is split between them in proportion to their values. To take the previous example, if this new warrant traded at $10, the $2500 tax basis would be divided between the warrants and the stock in proportion to their total values — with $2500 worth of stock and $1000 worth of warrants, this would be 5/7 to the stock and 2/7 to the warrants.*

If the warrants are worth less than 15% of the market value of the stock, the cost basis becomes zero by default — but a taxpayer can choose to have them taxed under the same system as above, with tax bases distributed in proportion to market value. Which is better? That depends on which one you want to sell first: if you want to sell the warrants, you’d want their tax basis to be as high as possible (depending on the price of the stock and warrant on the issue date, compared to your cost basis, you may be able to extract some cash from selling your warrant without paying any capital gains taxes at all — even though you didn’t pay any money to receive the warrant!).

Most tax transactions are much simpler than this (and that’s quite fortunate!), but as they say in the software business, 90% of the effort is spent solving the first 90% of the problem — the last 10% of the problem requires the other 90% of the effort.

* A warrant issue may lower the share price of the company. In general, changes in the capital structure do not change the total market value of the firm, so if the firm is worth $10 million, and decides to issue warrants that will raise $1 million, but have a market value of $2 million, one would expect the value of the outstanding stock to drop to $9 million. Why? Because the company was worth $10 million before, and is getting another $1 million; this $11 million will be owned by the the shareholders and the warrant-holders. Since the warrants are worth $2 million, the remaining $9 million will belong to the shareholders. Of course, this leaves them even: they now own $11 million worth of company, instead of $10 million — but they have to put another $1 million into the company in exchange. Of course, actual examples are more complicated: if shareholders think the company will invest this new cash wisely, a dividend issue might raise the total market value; if investors worry that the company will squander the new funds, this can lower the market value instead.


One Response to “Tax Q&A: “What is my tax liability when I sell stock?””

  1. Rigoberto Cloepfil Says:

    Firstly, sorry for the huge comment: my opinions are particularly subjective but I wanted to supplement this amazingly piece of writing with my own experience. Between my wife and I, we’ve worked in private equity for a number of years before dropping out due to the grueling lifestyle. In terms of investing, we’ve seen a LOT of people make it! and a huge sum of people LOSE everything. Needless to say, you do NOT want to be the latter. With the inflation and drug wars going on, just seeing the capital gains tax hitting your already negative revenue is not a pretty thing. Sometimes, I really feel that investing is a roll of the dice. I don’t mean like gambling..but for example, I read up on the NOVA article by Delos Chang (talks about technical analysis / chartists and fundamental analysis). Really inspired me to go invest in the Japanese yen through futures for my hedge fund. A few weeks later, would you know it…the tsunami hits and the yen appreciates in value because all those poor Japanese citizens are cashing in on their insurance who has to liquidate assets from overseas into yen. Basically, supply and demand. Of course, we can’t see everyone in terms of price tags, we have to really consider the drug wars and scandals in Japan right now but that’s what I mean! Really a roll of the dice. Anyway, long story short, if you really want to make some money, I’d consider investing in currency. Just my two cents. Thanks for reading.

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