VITA: 01

1. VITA: 01/16/10Chapter 10 Part 1: Capital Gains and Losses (Stock/Mutual Fund Sales and Sale of Principal Residence) Winter 2010 Kristina Shroyer

2. Lesson 10: Capital Gains and Losses Blank Forms for this Lesson As we go through this lesson you'll want to use some of the blank forms in Publication 4491-W for reference (blank forms start on Page 215) There are also a couple of forms from the Chapter I'll point out as we go Form 1040 (page 215) Look at Line 13 Schedule D (page 242-243) This is the support/backup for line 13, where the details of line 13 are summarized Note: Cancellation of Debt will be discussed Part 2 of the Chapter 10 Slides In general capital gain or loss refers to income or losses the taxpayer incurred from trading investment property.In general capital gain or loss refers to income or losses the taxpayer incurred from trading investment property.

3. Lesson 10: Capital Gains and Losses Sales of Assets/Investment Property – Capital Gain or Loss In general when a taxpayer sells an asset they must pay taxes on any profit (capital gain) they make on the sale If they taxpayer has a loss (capital loss) on the sale they rules for the deductibility of the loss vary based on the type of asset and the taxpayer's situation What is in the scope of VITA for this topic? Stock/Mutual Fund Sales Sale of Principal Residence (main home) Very Limited Cancellation of Debt related to Foreclosure/Abandonment We'll Discuss this in Part 2 of the slides Any taxpayer with sales of assets/investment property other than the above types should be referred to a professional tax preparer In general capital gain or loss refers to income or losses the taxpayer incurred from trading investment property.In general capital gain or loss refers to income or losses the taxpayer incurred from trading investment property.

4. Lesson 10: Capital Gains and Losses How are Stock Sales Reported to the Taxpayer? Form 1099-B Let's take a look at the form I got all these forms from the IRS website Go to http://www.irs.gov/formspubs/index.html?portlet=3 - I usually then select "Download Forms and Publications – Form and Instruction Number" We'll look at the form in more detail as we go but this is the general idea and the main lines you will see numbers in Line 1 will show the date of the stock or mutual fund sale Line 2 will show the proceeds received Line 4 will show any Federal Income tax withheld from the sale proceeds How is the Sale of a Principle Residence Reported to the Taxpayer? Generally (not always) reported on Form 1099-S If not reported on Form 1099-S you will need to get the closing papers on the sale from the taxpayer We'll look at 1099-S more closely later in the lecture

5. Lesson 10: Capital Gains and Losses How are capital gains and losses reported on the tax return? First a Schedule D is filled out to determine the overall deductible gain or loss This form is on page 242-243 of your Publication 4491-W The deductible gain or loss goes on line 13 of Form 1040 In the Interview/Screening process you will need to determine whether the taxpayer has sold any stock, mutual funds, or a home that is their principal residence For the interview, first look for the Forms 1099S or 1099B – but don't assume because they don't have the Forms they haven't sold assets, make sure and ask them in the interview If they have sold anything other than a principal residence or stock/mutual fund they should be referred to a professional If they have forgiveness of debt on a principal residence they may be within the scope of VITA (we'll discuss this in more detail later) Page 10-1 in your Publication 4491 cites some other sources of information for these topics – you can find everything at the IRS website

6. Lesson 10: Capital Gains and Losses What information is needed to report Capital Gains and Losses? Basis/Adjusted Basis Holding Period (Short Term or Long Term) Proceeds from the Sale For Stock Sales you will get the Proceeds and Sale Date on Form 1099-B For Sale of Principal Residence you will get the Proceeds and Sale Date on Form 1099-S Gain or Loss = Proceeds from Sale – Basis/Adjusted Basis The Schedule D basically lists each stock/mutual fund/other asset sale and calculates the gain or loss for each one, the taxpayer then pays tax on the net gain or loss from all the sales I'm going to start out talking about stock and mutual fund sales but you're going to see these concepts also apply to sale of principle residence and foreclosures/abandonments (part 2 of this lesson) You'll see when you start using the TaxWise software the computer does the calculations for you You just enter the sale date, sales proceeds, purchase date and basis However you need to be able to read the forms to make sure everything is calculating right – DON'T RELY on the computer So we're now going to go through how you are going to get each of the three pieces of information from the taxpayer to report capital gains and losses as well as what these three pieces of information areSo we're now going to go through how you are going to get each of the three pieces of information from the taxpayer to report capital gains and losses as well as what these three pieces of information are

7. Lesson 10: Capital Gains and Losses Basis/Adjusted Basis - What is the basis of Stock? The basis of a stock or other property is usually it's COST. NOTE: This information MUST be provided by the taxpayer It will NOT be reported on the 1099-B Sometimes the broker may give the taxpayer a year end statement that provides this information but they are not required to (See Page 10-7 for an example) You can NOT calculate the basis for the taxpayer The best thing to do for a taxpayer that needs help calculating their basis is to refer them to their stockbroker They may need to dig into their past financial records If the taxpayer cannot provide the basis for their property the IRS deems the basis to be zero There are special rules for determining the basis of a stock acquired by means other than purchase or inheritance (we'll talk about special inheritance basis rules in a second) Any stock acquired by means other than purchase or inheritance is out of the scope of VITA

8. Lesson 10: Capital Gains and Losses Basis/Adjusted Basis - What is the adjusted basis of Stock? Sometimes amounts should be added or subtracted to the original cost of a stock or property to get the actual basis to use when calculating a gain or loss This is called calculating the adjusted basis, adjusted basis is the result of making additions and/or subtractions to the original cost basis The most common addition to basis you will see is commissions or fees paid when a stock is purchased or sold Let's say the taxpayer paid $1000 for 100 shares of stock plus $25 commission on the purchase, the taxpayer's total basis for that stock is $1025 If the taxpayer sold the stock for $2000, the gain is $975 ($2000-1025) Some other adjustments to basis Stock Splits A four for one stock split means every one share of the taxpayers stock is now four shares This in effect decreases price per share So if a taxpayer bought 1000 shares of $1,000 the original cost per share is $1 If there was a 4 for 1 split on the about the cost per share is now - $0.25/share Stock Dividends In this case taxpayers get additional shares of stock instead of cash dividends…as we saw above additional shares decreases basis Any stock dividends the taxpayer receives should be spread over all the shares…so if they bought 1000 shares for $1,000 (cost per share $1) but then received a 100 share stock dividend they now have 1100 shares for $1000 (cost per share is 91 cents per share) Note: Cost per Share (total cost of shares/# of shares) Look at the Example on page 10-3 of Publication 4491 So on the last slide we were talking about BASIS….now we're talking about ADJUSTED BASISSo on the last slide we were talking about BASIS….now we're talking about ADJUSTED BASIS

9. Lesson 10: Capital Gains and Losses Basis other than Cost - Sometimes cost cannot be used as basis, in these cases FMV (Fair Market Value) or another adjusted basis calculation is used, most of these cases are outside the scope of VITA and should be referred to a professional tax preparer Cases where basis other than cost is used and that should be referred to a professional tax preparer Property Received as a Gift Inherited Property Basis should be the Fair Market Value of the property at the date of the decedent's death FMV at DOD rule From the way I read it you can do returns for inherited stocks/mutual funds as long as the FMV at DOD rule is used However the estate can elect to use an alternate valuation date or other acceptable method This is out of scope of VITA

10. Lesson 10: Capital Gains and Losses Holding Period – Long Term or Short Term Remember this is the second item you need to know to report capital gains and losses: Basis/Adjusted Basis, Holding Period, Proceeds from Sale To determine the holding period of stock or property the taxpayer must provide the purchase date to determine the holding period of the property Holding Periods Short Term (a year or less) Long Term (more than a year) The holding period begins on the day after the shares were purchased The holding period ends on the day the shares were sold If a stock or investment property is inherited its holding period is long term no matter what If a stock has had a split or dividend the holding period is the same as the original stock (no new holding period) Holding periods are important because long term gains have a more favorable tax rate than short term gains

11. Lesson 10: Capital Gains and Losses Holding Period – Long Term or Short Term Complicated stock situations such as wash sales, like kind exchanges or worthless securities should be referred to a professional tax preparer What is a mutual fund? A mutual fund pools money together from thousands of small investors and then its manager buys stocks, bonds or other securities with it. When you contribute money to a fund, you get a stake in all its investments. This allows the investor to diversity in investments and professional management. Capital Gain Distributions vs. Sales of Investments Mutual funds can have both (and can receive both a 1099-DIV to report capital gain dist and a 1099-B to report shares they sold themselves) Capital Gain Distributions are reported on a 1099-DIV and are a result of sales within the mutual fund (the taxpayer themselves did not sell anything) Let's look at form 1099-DIV (line 2a) Always long term and go on a special place on the Schedule D The taxpayer will only receive a 1099-B if they actually sold shares of their fund How to calculate the basis of each stock share Taxpayers may not sell all their shares in a stock or fund at once and these shares may have been purchased at different times A taxpayer may direct a broker on which shares to sell This must be done at the time of sale not later If this is done use the specified shares to determine the basis and holding period If the taxpayer does NOT do this (which is normally the case) Use FIFO First/Oldest shares purchased were the ones sold. See Example on Page 10-6

12. Lesson 10: Capital Gains and Losses What Information to get from Form 1099-B The taxpayer will need to provide information on the basis/adjusted basis of their stock/investment and on the purchase date The rest of the information you will get from the 1099 – B Sales Date – The sales date of the stock is reported in Box 1a of Form 1099-B So when you use the software you will enter the purchase date and the sales date and the computer will use this to calculate the holding period Entering the dates correctly is very important Sales Price – The sales price of the stock is reported in Box 2 of form 1099-B There are two boxes next to where the sales price is reported If the Gross Proceeds box is checked Ask the taxpayer for the amount of commissions and fees paid on the sale and add it to the taxpayers stock BASIS If the Net Proceeds box is checked This means the broker has subtracted commissions and fees from the sale so no adjustment to the basis is needed (subtracting it from the sale has the same effect as adding it to the basis) Look at the Example on bottom of page 10-6 Look at the Exercise on page 10-7 (make sure and read this one)

13. Lesson 10: Capital Gains and Losses How to enter Stock/Mutual Fund Sales on Schedule D In TaxWise you will just enter the information reported in the proper places and it will be put into the correct section of the forms However you should understand how it works on paper so you know it is correct You should ALWAYS check all the forms on the taxpayers return and make sure each figure is correct Before you start entering data make sure you have the sales dates/sales prices from the 1099B's and the adjusted basis/purchase dates from the taxpayer Sch D Part I – Short Term Sales are reported here Sch D Part II – Long Term Sales are reported here Where are Capital Gain Distributions Reported? Again when using the software if you enter this in the correct spot it will be reported in the correct spot If a taxpayer ONLY has Capital Gain Distributions (only a 1099-DIV) the amount is entered directly on line 13 of form 1040 So in this case no Sch D is used If a taxpayer has a 1099-DIV and a 1099-B then: Capital Gain Distributions are always long term and are reported on Schedule D Part II, Line 13

14. Lesson 10: Capital Gains and Losses How to enter Stock/Mutual Fund Sales on Schedule D Once you have Part I and Part II of the Sch D completed The short term gains/losses will be combined to compute a net short term gain/loss The long term gains/losses will be combined to compute a net long term gain/loss The long term and short term capital gains/losses are then combined Losses cannot exceed $3000 per year If the losses for the year exceed $3000 the excess is carried forward to the next tax year where it can be used Losses carried forward keep their ORIGINAL holding period We'll talk a bit more about carryforward losses in a second Let's look at the Exercise on Page 10-9 (Question 3)

15. Lesson 10: Capital Gains and Losses Capital Loss Carryovers Taxpayers cannot take losses of more than $3,000 ($1,500 for MFS) in any one year Unused losses are carried forward until they are used up A taxpayer may have an used carry forward loss from 2008 – you'll need to find this information out If TaxWise was used in 2008 the information is on Worksheet 2 If some other tax software was used or the taxpayer had the return prepared professionally in 2008 you may be able to find the information in a worksheet If tax software was not used to prepare the prior year return: Use the worksheet in the Sch D instructions to compute a carry forward from 2008 to 2009 The 2008 carry forwards go on Part I line 6 or Part II line 14 Note that TaxWise will automatically calculate a taxpayer's capital loss and if over the limit the carry forward.

16. Lesson 10: Capital Gains and Losses Sale of a Home (Principle Residence) This is the second type of asset sale within the scope of VITA The second capital gain/loss within the scope of VITA is the sale of a taxpayer's MAIN home During the interview process you will determine if the taxpayer sold their principal residence ("main home") during the year If they did sell their home for a gain, all or part of it may be excludable from taxable income Who must REPORT the sale of a home? Taxpayers must report the sale of a home if any ONE of the following is true: The taxpayer does not meet the ownership test The taxpayer does not meet the use test During the two year period ending on the date of sale the taxpayer has excluded the gain from the sale of another home The gain from the sale is more than the taxpayer can exclude (maximum exclusion) The maximum exclusion is $250,000 for individual taxpayers and $500,000 for Married Filing Jointly

17. Lesson 10: Capital Gains and Losses What is a main home? This is the first thing you must determine Only the sale of a taxpayer's main home is within the scope of VITA Only a gain on the sale of a taxpayer's main home may be potentially excluded from taxable income A taxpayer's main home is where the taxpayer lives most of the time It does not have to be a traditional house The main home cannot be chosen by the taxpayer (see example on 10-12) NOTE: A taxpayer does NOT get to deduct a loss on the sale of their main home So they may have to report some or all of their gain (or none) but they never report a loss on the sale Once you've determined the taxpayer sold their main home you start looking at whether they meet the tests to be able to exclude the gain Also start looking at whether or not they have to report the sale of the home Remember the four tests

18. Lesson 10: Capital Gains and Losses Ownership and Use Tests The taxpayer must meet BOTH of these tests to be able to exclude all or part of the gain on the sale of their main home Ownership Test The taxpayer must have owned the home for at least two years The two years do not have to be continuous – HOWEVER, the taxpayer must show they met the ownership test for a total of 24 months (2 years) during the five year period ending on the date of sale Use Test The taxpayer must have lived in the home as their main home for at least two years The two years do not have to be continuous – HOWEVER, the taxpayer must show they met the ownership test for a total of 24 months (2 years) during the five year period ending on the date of sale Reduced Exclusion If the taxpayer doesn't meet the above test but meets some special circumstances they may qualify for this This is out of the scope of VITA – refer to professional taxpayer

19. Lesson 10: Capital Gains and Losses Prior Exclusion Test To qualify for the exclusion on the sale of a home the taxpayer cannot have claimed on exclusion on the sale of another home during the two year period ending on the sale date Married Homeowners Individual taxpayers get an exclusion of up to $250,000 if they qualify Married Homeowners can exclude up to $500,000 if they meet ALL of the following tests They file a joint return (MFJ) One or both of the spouses meet the ownership test BOTH spouses meet the use test NEITHER spouse excluded a gain in the two years prior on a home sale If both spouses don't meet ALL of the above tests, another calculation is done This calculation is outside the scope of VITA and they should be referred to a professional tax preparer

20. Lesson 10: Capital Gains and Losses Calculating the Gain/Loss from Sale of a Main Home You do this once you have figured out the taxpayer is eligible for an exclusion on any gain on the sale (four tests) The General Process: First figure out the REALIZED gain or loss This is just the gain or loss without taking the exclusion into consideration (it is calculated in a way similar to the gain or loss on stocks/mutual funds) Basically amount realized on sale – adjusted basis = realized gain or loss If there is a loss on the home sale you are finished, nothing needs to be reported on the tax return (see important note below) NOTE: However, even though you're not required to report this on the tax return it's a good idea to report it anyway because without it you could generate a document matching error for the taxpayer If there is a realized gain, figure out the allowable exclusion ($250,000 or $500,000) If the allowable exclusion is greater than the realized gain none of it is taxable and nothing is reported on the tax return (see note below) NOTE: However, even though you're not required to report this on the tax return it's a good idea to report it anyway because without it you could generate a document matching error for the taxpayer If the allowable exclusion is less than the realized gain the sale must be reported on Schedule D

21. Lesson 10: Capital Gains and Losses Figuring out the Realized Gain or Loss First determine the Selling Price This is basically the gross proceeds received from the sale If the taxpayer receives 1099-S: Box 1 shows the sales date Box 2 shows the gross proceeds from the sale If the taxpayer doesn't receive a 1099-S You will need to use the closing papers on the loan Next determine the Amount Realized This is the selling price minus any selling expenses Selling Expenses: commissions, advertising fees, legal fees, loan charges, points There is a worksheet in TaxWise that will help you do this Or you can use Worksheet 2 of Publication 523 (get at www.irs.gov) Page 13

22. Lesson 10: Capital Gains and Losses Figuring out the Realized Gain or Loss (cont.) Next Determine the Basis This is the cost if the taxpayer purchased or built the home If the taxpayer inherited the home the basis is FMV at DOD If the taxpayer got the home as a gift or inherited it and needs to use a method other than FMV at DOD refer them to a professional tax preparer Finally Determine the Adjusted Basis As with stocks basis can be increased or decreased by certain amounts Increases Improvements to the home The improvements should have a useful life of more than one year Decreases Deductible casualty losses, depreciation Adjusted Basis = Basis + Increases – Decreases Worksheet 1 in Publication 523 can also be used for Adjusted Basis Page 12 Gain/Loss on Home Sale = Amount Realized – Adjusted Basis Worksheet 2 of Publication 523 also does all this Page 13 of Publication 523

23. Lesson 10: Capital Gains and Losses How much of the gain from a main home sale can the taxpayer exclude? If all requirements are met the an individual taxpayer can exclude up to $250,000 of the gain and married taxpayers can exclude up to $500,000 of the gain If not out of VITA scope Where to report any taxable gain? Gains on the sales of main homes do NOT need to be reported if the gain is less than the taxpayer's exclusion Though as I said earlier I recommend reporting them anyway to avoid document matching errors Losses on sales of taxpayer's main homes are not deductible and are not reported Though as I said earlier I recommend reporting them anyway to avoid document matching errors Gains in excess of the taxpayer's exclusion must be reported on Schedule D So if the taxpayer's gain is over $250,000/$500,000 the excess amount needs to be reported It is going to be reported in the long term section of the Schedule D See Page 10-17 for an example The entire gain is reported and the exclusion is then subtracted

24. Lesson 10: Capital Gains and Losses Five Year Test Period Suspension If the taxpayer is on "qualified official extended duty" as a member of the Armed Forces they can choose to have their five year test period suspended Read through the page 10-18 on this for more, we don't generally get many members from the Armed Forces at our site but if we do the information is here