Attention investors: Don't overpay the taxman

No doubt about it, doing a tax return is a hassle. All those 1099 forms, the W-2 and the task of computing work-related and charitable deductions can make you want to bang your head on the desk.

But all that’s the easy part. For many people, the biggest challenge is computing capital gains and losses on investments. While most other tax-return issues involve events of the past year, calculating capital gains can require records going back decades.

And the stakes are high. Faced with big budget deficits, some members of Congress want to tighten up on capital gains reporting, arguing that the government is missing out on tens of billions of dollars of taxes due every year. The push could turn into new reporting standards when stocks and other investments are purchased, and there may be more audits.

Even without this new worry, capital gains calculations deserve close attention because a mistake is as likely to make you pay too much tax as too little.

The basics
Capital gains are the profits earned when you sell an asset for more than you paid — the "cost basis." The difference is subject to either a short- or long-term capital gains tax. (This generally does not apply to to assets held in tax-favored accounts like 401(k)s and IRAs.)

Sell a stock, mutual fund share or other asset you’ve owned longer than 12 months and you’ll owe a maximum of 15 percent tax on the profit. Sell the same investment 12 months or less after buying it and the profit is taxed as a short-term capital gain, at a rate as high as 35 percent.

Losses are figured the same way — by subtracting the cost basis from the sales proceeds to get a negative number. Losses can be subtracted from gains on other investments you sold to create a net gain or loss for the entire year. If losses exceed gains, the extra loss can be used to reduce your taxable income by up to $3,000 a year. Larger losses can be “carried forward” and used to offset capital gains or income in future years.

Sounds easy enough. The sales all too place in 2007, and brokerages provide summary statements by the end of January. The real problem is finding and using the correct cost basis.

If you used the same brokerage to buy and sell the asset, the firm probably will have this figure. But in many cases you may need to dig back through your records to find the purchase price.

For inherited stocks or other assets, the cost basis is the price on the day the previous owner died. If assets are received as a gift, your cost basis is the same as the giver’s.

Several things can make the cost calculation even more complicated.

Partial-sales math
First is when you sell a block of shares that were bought over time at various prices. In this case, add up the total paid over the years for all the shares you sold, then subtract that from the sales proceeds. The result is the capital gain or loss.

What if you sell just some of the shares?

The easiest approach is to figure the average price paid. Tally all the money spent on shares over the years and divide by the number of shares you had before the sale. The result is an average cost per share. Subtract this from the sales price per share to figure the profit on each share, then multiply the result by the number of shares sold.

This way, you can use the same purchase price if you sell another batch later.

When just part of a holding is sold, many investors prefer to minimize any capital gains tax -– or maximize their tax loss. They do this by selling the shares for which they paid the highest price, leaving the smallest possible profit (or biggest loss).

If you want to sell a specific block of shares, the IRS requires that you give this instruction to your broker or fund company when you order the sale, and that you get written confirmation.

Selling specific blocks of shares means you must have good records in case the IRS asks you to prove the cost basis you use.

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