One of the considerations for most types of investments is that tax liability that you will incur when you sell your investment for a profit in the future. In the case of stocks, you may need to pay taxes on income you receive while you hold your investment, as well as on profits you receive in the end. But other occurrences, such as stock splits, will not affect the amount of tax you owe.
How Stock Splits Work
Companies that issue stock may decide to split that stock. In a stock split, investors receive additional stock based on the number of shares they own. However, the value of each share drops to reflect the new number of outstanding shares. A typical stock split may double the number of shares but cut each share's price in half. Investors neither gain nor lose value on a stock split, unless the decision to split stock affects the market for the stock independently.
Capital Gains Taxes
Unlike cash dividends, on which stockholders must pay income taxes when they receive them, stock owners do not need to pay taxes on stock, regardless of whether it splits or changes value, until they sell. When you sell stock that has split, you must pay income tax on your capital gains, which are the profits you earned over the life of the investment. If you sell stock for less than you paid for it, you realize a capital loss, which can offset capital gains from other investment sales or reduce your taxable income from other sources.
Adjusting Your Cost Basis
Two facts of stock splits prevent you from paying any additional tax when you sell and report your capital gains. The first is the fact that each share of the old stock you sell has only a fraction of the value it had before the split, while the stock you gained from the split makes up for the rest of the total value. The second important consideration is the fact that a stock split changes your cost basis. Cost basis is the price you paid to acquire stock, and the amount you subtract from your sale price to determine your capital gains. Instead of claiming a cost basis of zero for the shares you gain in a split, you must divide the cost basis of each original share to cover the new shares they produce equally.
The outcome of adjusting your cost basis is neither a net gain nor a net loss when it comes to claiming capital gains. If you acquired stock for two different prices before the split, you must reduce the cost basis for each old share to cover each new share. For example, if you purchased 100 shares for $40 each, and a year later bought another 200 shares for $44 each, a two-for-one stock split will leave you with 600 shares. Reversing the ratio of the split (two-for-one) means you must cut your cost basis in half. This leaves you with 200 shares with a cost basis of $20 per share and 400 shares with a cost basis of $22 per share. If you sell all of your stock, you may subtract the full $12,800 cost basis from your total sale price, which is the same amount you'd be able to subtract if you sold half as many shares for twice the price prior to the split.
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