It is very important to know how to compute capital gains. This skill is essential if investors hope to stay on top of their tax obligations and remain in good standing with the IRS. Failure to pay can lead to serious consequences of many different varieties. So, it is best to simply do things right the first time and compute capital gains correctly so they can be paid and trouble avoided. Of course, it must be noted that investors who work with financial advisors and get help have a significant advantage in this area.
By working with a financial advisor on your investments, you are essentially designating a finance professional to do the computing for you. Even so, it is good to know how to do the computation, because even in learning the mechanics of it we can learn more about what exactly capital gains are and why we have to pay for them as taxpayers and investors.
Capital Gains Taxes
Gains that are made on equities such as stocks or mutual funds are subject to capital gains taxes. To give a very simple example, if an investor bought a single stock, took dividends in cash, and then sold the stock at some date down the road, computing capital gains is pretty easy. The investor's gain is just the difference between the cost basis of the stock and the investor's net income upon selling it. The cost basis was the share price plus any commissions the investor paid. And the net income at sale was the amount of money the stock went for minus the fee the investor paid to get it sold.
It is important to point out that this is an example of a realized gain. A realized gain in very basic terms is a capital gain that the investor actually got to see and put in his pocket. If he had just held the stock, it would have not been a realized gain even if the stock kept going up in value. The potential gain that exists in stock an investor possesses but has not yet done anything with is called unrealized gain. Investors do not have to pay taxes on unrealized gain, because it's just hypothetical, and prices of securities go up and down all the time. The only real gain we ever get (realized gain) comes when the cash from a stock sale is actually in our hands. This is important to keep in mind when analyzing your investments.
Cost Basis and Capital Gains
Determining cost basis is the first step toward calculating capital gains. The cost basis in this simple example, as mentioned earlier, was just the purchase price of the stock plus the commission the investor paid at the time of purchase. Cost basis can get complicated depending on how a security is acquired. Inherited and donated stocks are particularly complex as far as capital gains are concerned.
Another complication arises when multiple shares of the same stock are bought and sold. Employees of companies who buy shares of stock every pay experience this when they go to sell. Naturally, if an employee wishes to only sell a portion of her shares, she'll likely sell the ones she bought for the highest price to minimize capital gains. When selling stock, the exact shares sold must be specified and the cost basis determined using information from those shares that were sold. This is to prevent investors with large lots of the same stock from continually "selling" shares of stock at the highest price they ever paid to constantly evade capital gains. Computing capital gains is a simple concept that can get complicated in practice.