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When you sell a mutual fund or stock, do you really know how much money you have made? The answer is not as simple as many people think. In my tax practice, I have met too many people who do not understand the principle of “basis”, and as a result report too much gain. Each year, your brokerage firm will send you a form 1099-B, which shows the dollar amount that you received from the sale of securities. The form does not indicate your basis, and that is where an understanding of the term and good record keeping are essential. The result is that they needlessly pay too much tax to the government. Furthermore, the government will not be able to correct your mistake, because they only know what you tell them.
I do not ask people what they paid for any investment. That is a lesson borne from experience. Instead, I ask them when they bought it, how many shares they bought and how much they paid in total. That may seem like I am asking the same information, but I am not.
Stocks split and many people do not realize the impact that has on the way which they calculate their gain. Several years ago, I was reviewing a client’s previous tax return and could not understand why they had any capital gains to report. They had bought stocks such as CISCO and AOL, near the end of the tech bubble and when they sold them, they should have had losses. The culprit was that they had used the initial price per share and never took into account any stock splits. They had told me that the tax preparer at the mall had simply asked them what they had paid per share, and never went further. Fortunately, three years had not elapsed and together, we were able to file an amended return, reporting the correct basis information, and the taxable gain became a loss. As a result of that action, they received a refund of over $7,000.
Mutual funds are even trickier because the majority of investors have the dividends and capital gains that the mutual fund distributes reinvested in more shares of the fund. Each year, you will have paid tax on the capital gain and dividend distributions, and should not have to pay tax on that money again. The problem is that too many people forget about this and only remember purchases they made with out-of-pocket money.
Last year a tax client sold shares in USAA Cornerstone Strategic Fund, and received $26,613. They had told me that the basis was $8,950, which was their original investment. They thought that they had a taxable gain of $17,663 but they were wrong. Each year they had the dividends and capital gains reinvested, and those totaled over $18,252 which increased their basis to $27,202, and reduced their taxable gain to a loss of $589. This saved them over $2,300 in taxes!
If you have a mutual fund whose focus is income, you may find that your basis will exceed your sales price even though you have what appears to be a gain based on original purchases.
Over the past few years, many of the brokerage houses have tracked cost basis and this is less of an issue, but it is still one of the most frequent errors which people make. It is so important that people maintain good records and keep annual statements. After all, no one should pay more tax than they have too!