Every investment is judged by what it returns and by what is left after tax. This chapter defines total return, shows how cost basis is set and changed, explains the wash-sale rule and the short-term and long-term capital-gains treatment, and closes with the benchmarks and indices used to judge a portfolio. Dividend types and dates are in Chapter 4.
Words you need
- Return. What an investment earned over a period, usually stated as a percentage of what was put in.
- Income. Cash an investment pays out while you hold it: dividends from stock, interest from bonds.
- Capital gain / capital loss. The profit or loss when you sell for more or less than your cost basis. It is "realized" only when you sell; before then it is "unrealised".
- Total return. Income plus change in price, over the period, as a percentage of the starting value.
- Dividend. A distribution of a company's profit to its shareholders, set by the board of directors.
- Cost basis. What you are treated as having paid for a security. Gain or loss is sale proceeds minus basis.
- Holding period. How long you owned the security. It decides whether a gain is short term or long term.
- Wash sale. Selling at a loss and buying the same or a substantially identical security within a 30-day window around the sale.
- Benchmark. A standard, often an index, against which a portfolio's results are compared.
- Index. A published number that tracks the prices of a defined group of securities. You cannot buy an index directly; funds copy it.
Components of return
An investor can earn money from a security in two ways.
- Income. Dividends or interest paid in cash while you hold it.
- Capital appreciation. The price rises, so you could sell for more than you paid.
Total return = (income + change in price) / starting price.
Worked example. You buy 100 shares at $50 ($5,000). Over the year you receive $1.80 per share in dividends and the price rises to $56.
| Piece | Calculation | Amount |
|---|---|---|
| Income | 100 × $1.80 | $180 |
| Capital gain (unrealized until sold) | 100 × ($56 − $50) | $600 |
| Total | $180 + $600 | $780 |
| Total return | $780 / $5,000 | 15.6% |
The two pieces carry different risks. Income from a stable company is steadier; price change is volatile. Growth-oriented investors lean on appreciation, income-oriented investors on cash payments. A bond held to maturity returns income and a return of principal, with any gain or loss depending on purchase price (Chapter 7).
The exam also separates nominal return (before inflation) from real return (after). With a nominal return of 7.4% and inflation of 3.0%, the approximate real return is 7.4% − 3.0% = 4.4%.
Cost basis
Gain or loss on a sale is proceeds minus cost basis. Basis starts as the price you paid plus commissions and fees, and changes with events such as stock dividends, splits and return of capital.
How you acquired the shares changes the basis
| How acquired | Basis |
|---|---|
| Purchase | Cost plus commissions |
| Gift | The donor's basis carries over to you. If you sell at a loss, your loss is measured from the lower of that basis and the market value at the date of the gift (IRC §1015) |
| Inheritance | Fair market value on the date of death (a "step-up" or "step-down"), and the holding period is automatically long term |
| Stock dividend or split | Original basis divided over the larger number of shares |
| Reinvested dividends | Each reinvestment is a new purchase at its own cost |
When you hold several lots
If you bought shares at different prices, you must say which you are selling.
Worked example. You hold three lots of 100 shares: bought at $30, $40 and $50. You sell 100 shares at $55.
| Method | Lot treated as sold | Basis | Gain |
|---|---|---|---|
| FIFO (first in, first out), the default for stock | $30 lot | $3,000 | $2,500 |
| Specific identification (you name the lot before settlement) | $50 lot | $5,000 | $500 |
| Specific identification | $40 lot | $4,000 | $1,500 |
| Average cost (available for mutual fund shares) | all lots | $40 average | $1,500 |
Average basis: (3,000 + 4,000 + 5,000) / 300 = $40. The same sale produces a gain anywhere from $500 to $2,500 depending on the method, which is why the choice matters. Choosing the highest-basis lot defers tax now; it does not remove it.
Broker reporting of basis
Since the Emergency Economic Stabilization Act of 2008, brokers must report cost basis to the investor and the IRS on Form 1099-B for "covered" securities. Covered means acquired on or after 1 January 2011 for stock, 1 January 2012 for mutual fund shares and dividend-reinvestment plan shares, and 1 January 2014 for most bonds and options. For older "non-covered" securities the broker may not report basis, and the investor must keep records. The broker's default method is FIFO for stock and average cost for mutual funds unless the customer chooses another in time.
The wash-sale rule
The tax law does not allow you to sell at a loss and keep the position. If you buy the same or a substantially identical security within 30 days before or after the sale (a 61-day window including the sale day), the loss is disallowed for now. It is added to the basis of the replacement shares, and the holding period carries over.
Worked example. You sold 100 shares for $5,000 that had cost $7,000: a loss of $2,000. Fifteen days later you buy 100 shares at $48 ($4,800). The $2,000 loss is disallowed. New basis = $4,800 + $2,000 = $6,800, or $68 per share. If you later sell at $60, the gain or loss is $6,000 − $6,800 = a $800 loss, which you can use.
Worked example (partial). You sell 300 shares at a $3,000 loss ($10 a share) and buy back 100 shares within 30 days. Only the replaced one-third is disallowed: 100 × $10 = $1,000 disallowed, $2,000 allowed as a loss now.
The rule applies to purchases in an IRA or by a spouse as well. It affects losses only; gains are never "washed".
Capital-gains tax: short term and long term
| Holding period | Class | Tax treatment |
|---|---|---|
| One year or less | Short term | Taxed as ordinary income at the investor's marginal rate |
| More than one year | Long term | Taxed at preferential rates of 0%, 15% or 20% depending on taxable income |
The holding period starts the day after you acquire the security and includes the day you sell. A purchase on 10 March 2025 and a sale on 10 March 2026 is a one-year hold, which is still short term. A sale on 11 March 2026 is long term.
Higher-income investors may also owe the 3.8% net investment income tax on investment income above statutory thresholds of $200,000 (single) and $250,000 (married filing jointly) of modified adjusted gross income. These NIIT thresholds are set by statute (IRC §1411) and are not indexed; the income brackets for the 0/15/20% rates are indexed annually and are not stated here.
Netting. Gains and losses are netted within each class, then across classes. If losses exceed gains, up to $3,000 of the net loss a year can offset ordinary income (and $1,500 if married filing separately); the rest carries forward to later years indefinitely (IRC §1211(b)).
Worked example. A $600 gain on shares held 8 months is short term. At a 24% marginal rate the tax is $600 × 0.24 = $144. The same $600 gain after 14 months, at 15%, is $90. Waiting saved $54.
Municipal bond interest is generally federally tax-exempt, but a capital gain on selling a municipal bond is taxable like any other gain.
Benchmarks and indices
A benchmark answers: "compared with what?" A portfolio return of 6% sounds acceptable. If the right benchmark returned 11%, it is not.
| Index | What it tracks | How it is weighted |
|---|---|---|
| S&P 500 | About 500 large U.S. companies | Market capitalization (price × shares outstanding) |
| Dow Jones Industrial Average | 30 large U.S. companies | Price weighted |
| Nasdaq Composite | Most stocks listed on the Nasdaq exchange | Market-cap weighted |
| Russell 2000 | 2,000 smaller U.S. companies | Market-cap weighted |
| MSCI EAFE | Developed markets outside the U.S. and Canada | Market-cap weighted |
| Bloomberg U.S. Aggregate Bond Index | Investment-grade U.S. bonds | Market-value weighted |
The index must match the portfolio. Comparing a bond fund with the S&P 500, or a small-cap fund with the Dow, tells you nothing.
How weighting changes the answer
Three stocks, A, B and C, with prices $100, $50 and $30. Shares outstanding: A 10 million, B 100 million, C 200 million. Market capitalizations: A $1,000m, B $5,000m, C $6,000m, total $12,000m.
Stock A rises from $100 to $110; the others do not move.
| Weighting | Calculation | Index change |
|---|---|---|
| Price weighted | Sum of prices 180 → 190, so 190/180 − 1 | +5.56% |
| Market-cap weighted | Total cap 12,000 → 12,100, so 12,100/12,000 − 1 | +0.83% |
| Equal weighted | (10% + 0% + 0%) / 3 | +3.33% |
The price-weighted index is moved most by the highest-priced stock, regardless of company size. The cap-weighted index is moved most by the biggest companies. This is why the Dow can be influenced by a high-priced stock that is small in value, a favorite exam point.
Index funds and ETFs try to match an index; active managers try to beat it. A fund's gap from the benchmark is its tracking difference.
Key facts — Return and tax - Total return = income + price change, as a percentage of the starting price. - Gain or loss = proceeds − cost basis. Gift: donor's basis carries over. Inheritance: market value at death and long-term treatment. - Default basis method: FIFO for stock, average cost for mutual funds. Specific identification must be made before settlement. - Wash sale: loss disallowed if the same or substantially identical security is bought within 30 days before or after. Loss is added to the new basis. - Capital gain is short term if held one year or less, long term if more than one year. Capital losses offset gains plus $3,000 of ordinary income; the rest carries forward. - Price-weighted (Dow) versus cap-weighted (S&P 500). Compare a portfolio with a benchmark that matches it.
Exam traps
- "Total return is only the price change." It includes income.
- "A gain on a stock held exactly one year is long term." It must be held more than one year.
- "The wash-sale rule applies to gains." Only to losses, and the disallowed loss is added to the new basis, not lost forever.
- "Inherited stock keeps the decedent's basis." It is stepped to market value at death.
- "The Dow weights companies by size." It weights by share price.