| Stock Investment |
I could go on and on for hours -- and you'd probably fall asleep before
you got to the second paragraph. Instead, I'll try to answer a number of
DRP tax questions that are asked of me on a daily basis. While this is
certainly not the final word regarding DRPs and taxes, it should answer a
number of your questions.
Q. When I purchase my shares directly or receive more shares
with my reinvested dividends, I'm charged an "administrative" or "set up"
fee. What's that all about. Is this fee deductible? Can I add this fee to
the cost basis (for tax purposes) of my shares?
A. Probably not. DRP service charges are expenses for the
production of income and cannot be added to the basis of the shares
purchased. These service charges can only be deducted as a miscellaneous
itemized deduction on Schedule A, subject to the 2% limitation on Adjusted
Gross Income. So if you don't itemize your deductions, you're out of luck.
And even if you DO itemize, the 2% AGI limitation may reduce or eliminate
any tax benefit relative to these service charges.
Q. But how about purchase and/or sales commissions? Are they the
same?
A. Nope. DRP commissions paid, either directly or indirectly, in
order to purchase or sell shares are an adjustment to the basis of the
shares. Commissions charged to purchase shares are added to the cost of
the shares purchased. Commissions charged to sell shares are used to
reduce the gross purchase. So even if you don't itemize your deductions,
you'll get the tax benefit for the commissions.
Q. My DRP plan allows me to purchase shares at a discount. What
a great deal, eh? No tax problems there, right?
A. Not exactly. Uncle Sammy requires that if you purchase shares
at a discount, you must report the discount amount as income. You would
report the discount on Schedule B as dividend income. But the good news is
that your tax basis on these shares is increased to the fair market value
(FMV).
For example, let's say that you purchase your DRP shares at a 10%
discount from the company. The FMV of the shares is $30 when you purchase
them. So, taking the discount into consideration, you would only have to
fork over $27 for the shares. For tax purposes, you would report your $3
discount as dividend income, and your tax basis in the shares would amount
to the full $30.
Q. I never receive the dividend checks from the company. That
means that I don't have to report any dividend income on a yearly basis,
right?
A. That is not correct. You ARE receiving taxable dividends. You
are simply electing to take those dividends and purchase additional shares
of stock instead of taking the dividends in cash. While you may bypass the
"middle man" on the purchase transaction, you are really buying more
stock. That being the case, the company will issue you an IRS Form 1099DIV
to report the taxable dividends paid to you during the year.
Q. I get it. But if I am buying additional shares, don't I get a
tax basis for those shares?
A. You sure do. That is why DRP record keeping is so important.
For every additional share that you purchase, you have a new tax basis for
those shares. You will be constantly buying additional shares of stock at
different prices. Example time:
Let's say that you start your DRP investment with 100 shares purchased
for $5/share (or $500 total). You then have the following reinvested
dividend transactions: So what is your basis for all 108 shares? Do the math and you'll come
up with $542 for the whole shootin' match. Certainly NOT just the original
$500 that you paid when you began your DRP plan.
Not adding the reinvested dividends to the basis of the original shares
purchased is the biggest mistake that I see DRP investors make. The sad
thing about that is the investor's cost basis is understated big time when
the shares are sold, causing unnecessary tax dollars to be paid by the
investor. Don't let this happen to you. Understanding the tax mechanics
and keeping good records are the cornerstones of profitable DRP investing.
Q. OK. Things have gone well with my DRP plan, and I'm ready to
sell my shares. Since I have reinvested my dividends, I can use an
"average cost" basis when computing my gain or loss on the shares, right?
A. Sorry, you can't use "average cost" basis for DRPs. Even
though your DRP plan might feel like a mutual fund, it is not -- you are
buying stock. Only mutual funds are allowed to use the "average cost"
basis for accounting for gains and losses. Buyers of stock must use one of
two methods when they sell their shares: Q. How does FIFO work?
A. Pretty much just like it sounds. The shares that you purchase
first (first in) are deemed to be the shares that are sold first (first
out). It is really pretty easy. Watch...
Assume that you have the following DRIP transactions: On March 15th, the price of the shares reached $20/share, and you
decide to sell 13 shares. Obviously, your sales price would be $260 (13
shares X $20), but what would be your cost basis using FIFO? It would be
$186. Did you get it? Look closer. You would have sold all of the 10
shares originally purchased on Jan. 1 (10 shares X $15/share = $150.). And
you would have sold 3 of the shares purchased on Feb. 1 (3 shares X
$12/share = $ 36). So your basis would be $186 against a sales price of
$260, realizing a gain of $74. For any subsequent sales, you would begin
with the 4th share purchased on Feb 1st.
So, as you can now see, if you hold your DRP shares for the next 20
years, you may still have to get your hands on that very first DRP
confirmation slip to prove to Uncle Sammy the cost of that very first
share. So keep those DRP confirmation slips and year-end statements with
you at all times.
Q. How about specific shares. How can I do that?
A. Very, very carefully. The IRS has strict rules that must be
followed in order to "specify" shares of stock. For additional reading on
how to specify shares, check out my post on that very issue in the Taxes
Frequently Asked Questions areA. But it is NOT easy to do in a DRP
plan, especially when you are purchasing small lots and fractional shares.
They tend to get commingled and would not qualify for the specific
identification method.
Q. But... what if I were able to have my DRIP plan administrator
send me specific stock certificates representing my purchases. Would I
THEN be able to use the specific identification method?
A. Hmmm... what a great ideA. I sure wish I had thought
of it. You are exactly correct. If you can get your DRP plan to send you
the individual shares, representing specific shares purchased, you are on
your way to using the specific share method when you sell.
Using the above example, let's assume that the DRP administrator issued
us stock certificates for the shares that were purchased on a monthly
basis. Instead of being stuck with the FIFO method, we could have
"specified" the shares that we wanted to sell. That being the case, I
would have sold the 8 shares at $18.75/share, and 5 shares of the lot I
purchased for $15/share. That would give me a basis of $225, compared to
my sales price of $260. Using the "specific" method reduces my gain (and
therefore reduces my income tax on that gain) by $39 over that generated
by using the FIFO method.
Q. But at least if I hold my DRP plan for 20 years, all of the
gains will be long-term gains!
A. Not so fast. Think of what you just said. Now think of how
DRPs work. Every quarter (or three months) you are buying additional
shares of stock. This happens quarter after quarter. It never ends. So
sooner or later when you sell off your final lot, a small part of the gain
will generally be a short-term capital gain, since you held some of the
shares for a year or less.
So if you DO hold your DRP shares for 20 years, and then sell off the
whole kit and keboodle, the vast majority of the gain will be long term,
but you'll still have those last four quarters of reinvested dividends
that will receive short-term capital gain treatment.
Quarter 1: 2 shares @ $5/share
Quarter 2: 2 shares @ $5.25/share
Quarter 3: 2 shares @ $5.50/share
Quarter 4: 2 shares @ $5.25/share
1. First In First Out (FIFO), or
2. Specific Identification
January 1st: Buy 10 shares @ $15/share
February 1st: Buy 12.5 shares @ $12/share
March 1st: Buy 8 shares @ $18.75/share
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