Information about Capital Gains and Losses Needed for the Series 7 Exam
Capital gains are profits made when selling a security, and capital losses are losses incurred when selling a security. To determine whether an investor has a capital gain or capital loss, you have to start with the investor’s cost basis.
The cost basis is used for tax purposes and includes the purchase price plus any commission (although on the Series 7 exam, the test designers usually don’t throw commission into the equation). The cost basis remains the same unless it’s adjusted for accretion or amortization.
Incurring taxes with capital gains
An investor realizes capital gains when he sells a security at a price higher than his cost basis. Capital gains on any security (even municipal and U.S. government bonds) are fully taxed on the federal, state, and local level.
A capital gain isn’t realized until a security is sold. If the value of an investment increases (appreciates) and the investor doesn’t sell, the investor doesn’t incur capital gains taxes.
Capital gains are broken down into two categories, depending on the holding period of the securities:
Short-term capital gains: These gains are realized when a security is held for one year or less. Short-term capital gains are taxed according to the investor‘s tax bracket.
Long-term capital gains: These gains are realized when a security is held for more than one year. To encourage investors to buy and hold securities, long-term capital gains are currently taxed at a maximum rate of 15 percent, or 20 percent if the investor is in the highest tax bracket (for more information on capital gains and losses, visit the Internal Revenue Service website).
Offsetting gains with capital losses
An investor realizes a capital loss when selling a security at a value lower than the cost basis. Investors can use capital losses to offset capital gains and reduce the tax burden. As with capital gains, capital losses are also broken down into short-term and long-term:
Short-term capital losses: An investor incurs these losses when he has held the security for one year or less. Investors can use short-term capital losses to offset short-term capital gains.
Long-term capital losses: An investor incurs these losses when he has held the security for more than one year. Long-term capital losses can offset long-term capital gains.
When an investor has a net capital loss, he can write off $3,000 per year against his earned income and carry the balance forward the next year.
The following question involves capital-loss write-offs.
In a particular year, Mrs. Jones realizes $30,000 in long-term capital gains and $50,000 in long-term capital losses. How much of the capital losses would be carried forward to the following year?
The correct answer is Choice (B). Mrs. Jones has a net capital loss of $20,000 (a $50,000 loss minus the $30,000 gain). Mrs. Jones writes off $3,000 of that capital loss against her earned income and carries the additional loss of $17,000 forward to write off against any capital gains she may have the following year. In the event that Mrs. Jones doesn’t have any capital gains the following year, she can still write off $3,000 of the $17,000 against any earned income and carry the remaining $14,000 forward, which can be used to offset any capital gains the following year.
The wash sale rule: Adjusting the cost basis when you can’t claim a loss
To keep investors from claiming a loss on securities (which an investor could use to offset gains on another investment) while repurchasing substantially (or exactly) the same security, the IRS has come up with the wash sale rule; according to this rule, if an investor sells a security at a capital loss, the investor can’t repurchase the same security or anything convertible into the same security for 30 days prior to or after the sale and be able to claim the loss. An investor doesn’t end up in handcuffs for violating the wash sale rule; he simply can’t claim the loss on his taxes.
However, the loss doesn’t go away if investors buy the security within that window of time — investors get to adjust the cost basis of the security. For instance, if an investor were to sell 100 shares of ABC at a $2-per-share loss and purchase 100 shares of ABC within 30 days for $50 per share, the investor’s new cost basis (excluding commissions) would be $52 per share (the $50 purchase price plus the $2 loss on the shares sold), thus lowering the amount of capital gains he would face on the new purchase.
The following question tests your understanding of the wash sale rule.
If Melissa sells DEF common stock at a loss on June 2, for 30 days she can’t buy
I. DEF common stock
II. DEF warrants
III. DEF call options
IV. DEF preferred stock
(A) I only
(B) I and IV only
(C) I, II, and III only
(D) I, II, III, and IV
The answer you want is Choice (C). You need to remember that Melissa sold DEF at a loss; therefore, she can’t buy back the same security (as in Statement I) or anything convertible into the same security (as in Statements II and III) within 30 days to avoid the wash sale rule. Warrants give an investor the right to buy stock at a fixed price, and call options give investors the right to buy securities at a fixed price.
However, Statement IV is okay because DEF preferred stock is a different security and is not convertible into DEF common stock (unless it’s convertible preferred, which it isn’t; if it were convertible, the question would have told you so).
For Melissa to avoid the wash sale rule, she can’t buy DEF common stock, DEF convertible preferred stock, DEF convertible bonds, DEF call options, DEF warrants, or DEF rights for 30 days. However, she can buy DEF preferred stock, DEF bonds, or DEF put options (the right to sell DEF).