3-07 How to Record Gains and Losses

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. Imagine you made the following trades for LUV:

On December 31, LUV had a closing price of $75. So how much money did you make?

Unrealized vs Realized Gains

“Unrealized” gains and losses means that you still own the stock. Unrealized gains do not count towards taxes, because it is based on how the stock’s price is moving today-to-day. Your “Realized” gains (or losses) is how much extra money you have after closing your position – selling off the stock.

When we want to calculate our total gains and losses, we need to count both our Realized and Unrealized gains. When you file your taxes, you also need to separately consider your Short Term (you held the stock for less than a year) vs Long Term (you held the stock for more than a year before selling) realized gains, as they are taxed differently.

In the example above, there are three different ways to calculate our gains. The three methods will result in the same total, but will give different results for Realized and Unrealized.

First In, First Out (FIFO)

FIFO accounting means that when you calculate the gains from a sale of stock, you consider the gains based on the stocks you bought first.

This means that when I look at my “Sell” orders though the year, I divide them into buckets, and count each bucket one-by-one, selling off the “oldest” shares first.

FIFO Realized Gains

• I bought 100 shares at $50 on January 3. This is my first “bucket”.
• I bought 150 shares for $65 on June 21. This is my second “bucket”.
• I bought 50 shares for $70 on September 30. This is my third “bucket”.

With FIFO accounting, I need to empty the oldest “bucket” before going on to the next.

• On March 10, I sold 50 shares for $60.
  • These shares came out of my 1^st bucket (with 50 shares still remaining).
  • $60 sale price – $50 buy price = $10 profit per share, $500 profit total (50 shares x $10)
• December 10, I sold 100 shares for $55
  • The first 50 come out of my first bucket.
  • $55 sale price – $50 buy price = $5 profit per share, $250 profit total
  • The next 50 shares come from my second bucket.
  • $55 sale price – $65 buy price = $10 loss per share, $500 loss total

I would record my total “realized gains” as $500 + $250 – $500 = $250. This is what I would report to the IRS, and be taxed on. I held all of these stocks for less than a year, so this is considered “Short Term Gains”.

FIFO Unrealized Gains

For my unrealized gains, I need to calculate the remaining buckets against the $75 closing price on December 31.

• I still have 100 shares remaining from my second bucket, bought at $65 each
  • $75 closing price – $65 buy price = $10 profit per share, $1000 profit total
• I also have 50 shares from my third bucket, bought at $70 each.
  • $75 closing price – $70 buy price = $5 per share, or $250 total.

I would record my total “unrealized gains” as $1000 + $250 = $1250. I don’t report this to the IRS, and am not taxed on it.

My “Realized” plus “Unrealized” gains is $250 + $1250 = $1500.

Last In, First Out (LIFO)

LIFO uses the same bucket system but goes in the opposite direction. The stocks you bought most recently are the ones you sell first. Let’s look at our buckets again:

• I bought 100 shares at $50 on January 3. This is my first “bucket”.
• I bought 150 shares for $65 on June 21. This is my second “bucket”.
• I bought 50 shares for $70 on September 30. This is my third “bucket”.

LIFO – Realized Gains

With LIFO, I need to empty the newest bucket before going to the next.

• On March 10, I sold 50 shares for $60.
  • These shares came out of my 1^st bucket (with 50 shares still remaining). These are the only shares I owned at the time of this sale, so it is the same as FIFO.
  • $60 sale price – $50 buy price = $10 profit per share, $500 profit total (50 shares x $10)
• On December 10, I sold 100 shares for $55.
  • I start by taking shares out of my third bucket (the most recent shares I bought). There are 50 shares in my third bucket, so I take those out first.
  • $55 sale price – $70 buy price = $15 loss per share, $750 loss total.
  • The next 50 shares come out of my second bucket (my next-newest shares)
  • $55 sale price – $65 buy price = $10 loss per share, $500 loss total

With LIFO, the total is $500 – $750 – $500 = $750 realized loss.

LIFO – Unrealized Gains

I also need to calculate my unrealized gains.

• I still have 50 shares left in my 1^st bucket, and 100 shares left in my second bucket.
  • $75 closing price – $50 buy price = $25 profit per share, $1250 total ($25 x 50)
  • $75 closing price – $65 buy price = $10 profit per share, $1000 total ($10 x 100)

My total unrealized gains is $1250 + $1000 = $2250.

My “Realized” plus “Unrealized” is -$750 + $2250 = $1500, the same as FIFO.

FIFO or LIFO?

Under FIFO, I showed a short-term realized gain this year, and so I am taxed on that. With LIFO, I show a short-term loss – which I can write off my other income. Under LIFO, I still have shares that I bought in my first bucket. This means when I do eventually sell them in the future, I will have owned these shares for more than 1 year, and so it would be counted as a “Long Term” gain, and taxed at a lower rate.

This might make it sound like LIFO is the way to go, but it might not be the case depending on the transactions you make over the course of the year. FIFO very well may show that you have a loss for the year (because your have realized losses but unrealized gains), giving you a tax advantage by writing off your losses and carrying over the gains into the next tax year.

Average Cost Basis

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.

We won’t get into the same examples here, but this method is usually what your brokerage account uses to calculate the profit and loss on your Open Positions.

Mark's Tip

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.