Quick Answer
This page covers the tax consequences the exam outline gives as examples: basis (what was paid, adjusted over time), holding period (short-term at one year or less, long-term beyond it), dividend treatment (qualified dividends get a preferential rate if a holding-period test is met), and interest income (generally taxed as ordinary income).
A customer's tax status and tax considerations are already part of the investment profile. This section covers the mechanics behind them: how gain, loss, and income actually get taxed once a security is bought, held, and sold.
How Is a Security's Basis Determined and Adjusted?
- Basis is generally the cost of the security: the purchase price plus acquisition costs.
- Basis is adjusted for items properly chargeable to the capital account, forming the customer's adjusted basis, which is what the customer uses to compute gain or loss on a later sale.
- When a customer sells part of a holding bought at different prices, the
basis of the shares sold depends on which method applies:
- First in, first out (FIFO) is the default. If the customer does not adequately identify the lot being sold, the sale is charged against the earliest lot acquired.
- FIFO is not the default for shares the average basis method can cover. For those, with no election from the customer, the broker's own default method governs. The rule does not say which method that is. Its own examples show one broker defaulting to FIFO and another to average basis.
- Specific identification requires the customer to tell the broker which lot to sell no later than the earlier of the settlement date or the settlement time the trade-settlement rule sets, and to receive written confirmation of that instruction.
- The average basis method is available for shares of a regulated investment company (a mutual fund) and, for shares acquired after 31 December 2010, shares acquired through a dividend reinvestment plan.
Exam Tip: Gotchas
- Specific identification works if the customer names the lot to the broker by the earlier of the settlement date or the settlement time the rules set, and gets written confirmation. Naming it after the trade is still in time. Only a lot named after that deadline, or never named at all, leaves the sale on FIFO.
When Does a Holding Period Become Long-Term?
- The holding period begins the day after the trade date on which the security was acquired and ends on the trade date of disposition.
- Held more than one year: long-term capital gain or loss. Held one year or less: short-term capital gain or loss.
Exam Tip: Gotchas
- A security held for exactly one year is short-term, not long-term. The holding period must exceed one year; reaching one year is not enough.
When Does a Dividend Qualify for a Preferential Tax Rate?
- A dividend is a qualified dividend, taxed at a preferential rate, only if it is paid by a domestic corporation or a qualified foreign corporation, and the customer also meets a holding-period test: the stock must be held for more than 60 days within a 121-day period surrounding the ex-dividend date.
- The holding period is not the only test. A dividend also fails to qualify to the extent the customer is obliged to make related payments on a substantially similar or related position, which is what a hedge does.
- A dividend that fails either condition is taxed as ordinary income instead.
Exam Tip: Gotchas
- Owning the stock on the ex-dividend date is not, by itself, enough to make a dividend qualified. The holding-period test must also be met, or the dividend loses the preferential rate and is taxed as ordinary income.
How Is Interest Income Taxed?
- Interest income, such as bond interest and interest from cash equivalents, is generally taxed as ordinary income, unlike a qualified dividend or a long-term capital gain, either of which can receive a preferential rate.
What Should You Check on Exam Day?
- Default to FIFO unless the scenario shows the customer named a lot by the earlier of settlement date or settlement time, with written confirmation.
- Remember the average basis method's availability: mutual fund shares, plus dividend-reinvestment-plan shares acquired after 31 December 2010.
- Treat a one-year holding period as still short-term; long-term requires more than one year.
- Confirm both qualified-dividend conditions are met, the payer type and the holding-period test, before applying the preferential rate.
- Treat interest income as ordinary income by default, unlike qualified dividends or long-term gains.