Unfortunately, when it comes time to file your tax return, the IRS wants to know how much money you made or lost in your brokerage account. Your brokerage firm will even report to the IRS your total proceeds from all of your sales of stocks, but they don’t report your gains and losses. The reason they don’t report your gains or losses is that there are a couple of different ways of calculating it.
Recording the gains and losses of your stock portfolio seems pretty basic. You can simply list your cost of the security in your portfolio. When you sell it, record the price you received. The difference is your gain or loss on that stock. Simple right?
In the real world, however, things are not always that clear cut. You might buy 100 shares of LUV at $10, another $100 at $10.10 and then 50 shares at $11. Then, suddenly one day you need cash, and you sell 125 shares at $15. What was your profit on those 125 shares? As an investor, you must decide how you will record your cost. There are generally 2 methods that stock traders use. The first is First-in, First-out (FIFO) which simply means that you sold the shares that you bought first—in this case you would have sold 100 shares you bought at $10 and 25 shares you bought at $10.10.
The other way to calculate the cost is to use the “average cost basis” which means you average 100 shares at $10, 100 shares at $10.10 and 50 shares at $11 to get a total cost of $2,560 for those 250 shares which averages out to be $10.24 each.
[mark]Warning: The accounting for your stock transactions can get real messy real fast. So the best thing to do is to keep a running spreadsheet of all of the trades that you have made and keep track of the profitability of each trade and the cost of each of your open positions. There is nothing more frustrating or time consuming then sitting down on April 14th and trying to calculate the profit and losses on a whole year’s worth of trades. On top of that, you must keep track of which trades you held for the short-term and which you held for the long-term because Uncle Sam treats those differently. All of your gains are taxable, but you can only deduct $3000 per year in losses.
When working with your broker, accountant, and tax advisor, you’ll always have an up to date idea of where you stand with your investment activities using this simple recording method. You can then let your expert advisors handle the more complex accounting and tax issues involved in your investing activities.[endmark]