The hard thing about calculating your capital gains tax isn’t what rate to use (and there are several) but how to figure out how much capital gain you actually have. It’s a pesky little thing called cost basis that complicates everything so we’ll try and break it down for you. First, a general idea of how it all works.
Calculating Capital Gains Tax
Once you know how much you’ve profited, the rest is simple. You must only figure out whether it’s short-term gain or long-term gain, and then apply the appropriate capital gains tax rate, explained here.
As we mentioned in that post, short term gains are taxed as if they were regular income, so the tax on that profit is whatever tax bracket you’re in. For long-term gains, it’s probably a lower rate, either 0%, 15% or 30%.
What is the Cost Basis?
To figure out how much you actually profited when you sold your shares or other property, you have to figure out how much you actually paid for it.
Let’s say you inherited the investment, then you want to sell it. You didn’t pay a dime for it, so what is your cost basis? Simple: take the value of the investment on the day the original owner passed away. That’s the cost basis, which you will subtract from the selling price to arrive at your profit.
The cost basis is simply the price you paid for your stock, if that’s the capital you’re selling (if we’re talking real estate well same thing: cost basis is the price you paid for the property).
The Slippery, Sliding Cost Basis of Stock
What complicates stock sales is that over time you may have purchased more shares at different prices. Now, it used to be that it was up to you to keep track of your own cost basis.
Not anymore…sort of. Since 2011, brokers are required to keep track of more of this for you. But you still have to keep your own records, even if you just keep track of when you purchased, then look up the stock price for that day on any financial website. Moral of the story: keep those statements your brokerage sends you: you’ll need then at tax time for figuring stock basis, the year you sell.
How to Simplify Things
Reinvesting dividends of course is a nightmare when you want to figure cost basis. Sometimes it’s worth it to just accept a cost basis of zero since the difference is so small.
If you have a mutual fund, you can average everything for simplicity’s sake.