Section 3Function 3: Investment Products, Recommendations & Records
Tax treatment of securities transactions
52 min read
· Lesson 18 of 19
About This Lesson
Every trade in this course eventually meets the IRS, and this chapter is the meeting. The exam concentrates on a handful of high-yield rules: the one-year holding-period line, the $3,000 loss limit, the wash sale window, and the basis rules that differ for gifts versus inheritances, the single most-tested contrast in the chapter.
What you'll cover
capital gains and losses: holding periods, the $3,000 limit and carryforward, cost basis methods, and dividend taxation
the wash sale rule, its edge cases (option series, bond swaps), and the 61-day window
gift versus estate taxation (carryover versus step-up basis), the DRD, and FINRA Rule 2121's pricing precisions
This is the eighteenth chapter of the products module, and the second-to-last.
Capital Gains and Losses: Holding Periods and Tax Rates
The tax rate on capital gains depends on how long the investment was held.
The holding period begins the day after purchase and ends on the
day of sale.
≤ 12 months
Short-term capital gain/loss
Taxed as ordinary income at the investor's marginal tax rate. No special rate. Same as wages.
> 12 months
Long-term capital gain/loss
Preferred rates: 0% (low bracket), 15% (most investors), or 20% (high earners). Significantly lower than ordinary income rates for most investors.
Capital Loss Rules
Capital losses first offset capital gains of the same type (short-term vs. short-term, long-term vs. long-term)
Net losses can then offset gains of the other type
If losses exceed gains, up to $3,000 of net capital loss may be deducted against ordinary income per year
Excess losses carry forward indefinitely to future tax years
Losses maintain their character (short vs. long-term) when carried forward
Worked Examples: Capital Gains, Losses, and Wash Sales
Problem 1 — Capital gain/loss netting: An investor has the following transactions this year: • $14,000 long-term capital gain (stock held 18 months) • $6,000 long-term capital loss (stock held 2 years) • $9,000 short-term capital gain (stock held 4 months) • $15,000 short-term capital loss (stock held 8 months) Investor is in the 32% bracket. Calculate the net tax result.
1
Step 1 — Net same-type gains and losses: Long-term: $14,000 gain − $6,000 loss = $8,000 net LT gain Short-term: $9,000 gain − $15,000 loss = $6,000 net ST loss
2
Step 2 — Cross-net: $8,000 net LT gain − $6,000 net ST loss = $2,000 net LT gain
3
Tax on $2,000 net LT gain: At 32% bracket, LTCG rate = 15% $2,000 × 15% = $300 federal tax
4
If the result had been a net loss instead: up to $3,000 of net capital loss is deductible against ordinary income; excess carries forward.
Net result: $2,000 long-term capital gain, taxed at 15% = $300 federal tax. The short-term loss offset the LT gain, converting what would have been an $8,000 LT gain into $2,000.
Problem 2 — Wash sale and adjusted basis: An investor buys 200 shares of XYZ at $60 on February 1. She sells all 200 shares at $45 on September 15 (loss of $15/share). On September 30, she repurchases 200 shares at $47. She later sells all shares at $55 on March 10 of the following year. What are the tax consequences of each transaction?
1
September 15 sale — wash sale triggered: Repurchase on September 30 is within 30 days of the September 15 sale. The $15/share loss ($3,000 total) is disallowed.
2
Adjusted cost basis of replacement shares: Repurchase price + Disallowed loss = Adjusted basis $47 + $15 = $62 per share
3
Holding period of replacement shares: The holding period of the replacement shares includes the holding period of the shares sold at a loss — it "tacks on." Original purchase: Feb 1. Sale: Sept 15. Repurchase: Sept 30. Tacked holding period starts: Feb 1.
4
March 10 sale at $55: Adjusted basis = $62. Sale price = $55. $55 − $62 = −$7 per share loss ($1,400 total) This is a long-term capital loss (tacked period from Feb 1 to March 10 of following year = over 12 months).
5
What happened to the $3,000 disallowed loss? It was embedded in the $62 basis and reduced the gain (or increased the loss) on the March 10 sale. The loss was preserved — just deferred.
Sept 15 loss of $3,000 disallowed (wash sale). Replacement basis = $62. March 10 produces a $1,400 LT capital loss. The original $3,000 loss was not forfeited — it was deferred and ultimately recognized as part of the March 10 loss.
Cost Basis Methods and Dividend Taxation
Cost Basis Identification Methods
Sell shares you bought at several different prices and the cost basis method decides which lot just left, which decides your gain:
FIFO (first in, first out): The shares purchased first are sold first.
Default method. In a rising market, this tends to produce higher gains (older, lower-cost shares sold first).
Specific identification: The investor designates exactly which lot of shares is being sold.
Must be specified at the time of sale. Most flexible — can minimize taxes by selling the highest-cost lot.
Average cost: Allowed for mutual fund shares only. All shares are averaged together to determine cost per share.
Dividend Taxation
Qualified dividends: Paid by U.S. corporations and certain foreign corporations. Taxed at the same preferred rates as long-term capital gains (0%, 15%, or 20%). The investor must have held the stock for more than 60 days during the 121-day period surrounding the ex-dividend date.
Non-qualified (ordinary) dividends: Taxed as ordinary income at the investor's marginal rate. Includes dividends from REITs, master limited partnerships, and money market funds.
Concept Check
An investor in the 32% tax bracket sells stock held for 14 months at a gain of $10,000. What is the most likely tax rate applicable to this gain?
The stock was held more than 12 months, so the gain qualifies as a long-term capital gain and is taxed at preferential rates — not the ordinary income rate. For investors in the 22%, 24%, 32%, and 35% ordinary income brackets, the long-term capital gains rate is 15%. The 0% rate applies to investors in the 10%–12% brackets; the 20% rate applies to the highest earners (37% bracket). The 32% rate would apply only if this were a short-term gain (held 12 months or less).
Concept Check
An investor has the following capital gains and losses for the year: $8,000 long-term capital gain, $12,000 short-term capital loss, and $2,000 long-term capital loss. What is the net tax result?
Step 1: Offset same-type gains and losses. LT: $8,000 gain - $2,000 loss = $6,000 net LT gain. ST: $12,000 loss (no ST gains to offset). Step 2: Net across types. $6,000 LT gain - $12,000 ST loss = $6,000 net short-term loss. Step 3: Deduct up to $3,000 against ordinary income; carry forward $3,000 to the following year. Capital loss carryforwards maintain their short-term character.
Concept Check
A stock pays a $2.00 qualified dividend to an investor in the 32% marginal tax bracket. What is the correct federal tax rate on this dividend?
Qualified dividends are taxed at the same preferential rates as long-term capital gains. For investors in the 22%, 24%, 32%, and 35% ordinary income brackets, the qualified dividend rate is 15%. The 0% rate applies to 10%-12% bracket taxpayers; the 20% rate applies to those in the 37% bracket. The 32% ordinary income rate would apply to non-qualified (ordinary) dividends, such as those from REITs. The investor must also have held the stock for more than 60 days around the ex-dividend date for dividends to qualify.
Concept Check
An investor sells 100 shares from a position she acquired in three lots: 50 shares at $10 (oldest), 30 shares at $20 (middle), and 20 shares at $15. She does not specify which shares to sell. Under the default cost basis method, which shares are sold?
Under the default FIFO method, the earliest shares purchased are treated as sold first. The investor sells all 50 shares from the first lot at $10, all 30 shares from the second lot at $20, and 20 shares from the third lot at $15, for a total of 100 shares. Specific identification can override FIFO only if the investor designates the specific shares at the time of sale.
Section 2 of 4~10 min · 3 concept checks
Wash Sale Rule
The Wash Sale Rule
The wash sale rule blocks the oldest trick in tax-loss harvesting: selling for the loss while keeping the position. Sell at a loss and buy a "substantially identical" security within 30 days before or after (a 61-day window) and the loss is disallowed.
Disallowed is not destroyed: the loss gets added to the replacement shares' cost basis, so you recover it when the replacement is eventually sold.
Example: Jan 15 — Buy 100 shares of XYZ at $50.
March 1 — Sell 100 shares at $40. Realized loss = $1,000.
March 20 — Buy 100 shares of XYZ again at $42 (within 30 days). Result: The $1,000 loss is disallowed (wash sale).
New cost basis of replacement shares = $42 + $10 (disallowed loss) = $52.
What counts as substantially identical?
The same stock, bonds with the same issuer and maturity, options on the same stock.
A different company's stock in the same industry is NOT substantially identical.
Selling XYZ and buying ABC (a competitor) does not trigger the wash sale rule.
Wash Sale Edge Cases and Tax Swaps
The basic rule is foundational; the exam also tests the transactions that look like wash sales and are not.
Different Option Series Are Not Substantially Identical
IRS interpretation: An investor long an XYZ October 40
call sells the contract at a loss. Immediately after the sale, the investor
purchases an XYZ November 40 call.
Result: The IRS does not consider the November
call substantially identical to the October call. The loss on the October
contract is allowable. Different expiration months (or different strike
prices) place the contracts in different "series" for wash sale purposes.
Bond Swap Rules
The bond swap is tax-loss harvesting done right: sell a bond at a loss, buy a similar one, and avoid wash sale treatment as long as the new bond differs in at least one of three ways:
Different issuer
Different maturity date
Different coupon rate
Clear any one of the three and the loss stands while the fixed-income exposure stays roughly intact.
The Wash Sale Window
The window reaches 30 days before the loss sale and 30 days after; counting the trade date, 61 days under scrutiny. The rule touches only realized losses; gains can be repurchased freely.
Disallowed loss is not lost
forever. When a wash sale disallows a loss, the disallowed amount
is added to the cost basis of the newly purchased securities. The
investor recovers the loss when the replacement position is eventually
sold without triggering another wash sale.
Concept Check
An investor sells stock at a $2,000 loss on November 1. On November 25, the same investor purchases shares of the same stock. What is the tax consequence?
The wash sale rule disallows a loss if substantially identical securities are purchased within 30 days before or after the sale. November 25 is within 30 days of November 1, so the wash sale rule applies and the $2,000 loss is disallowed. The disallowed loss is not permanently lost — it is added to the cost basis of the replacement shares, preserving the economic loss for when those shares are eventually sold.
Concept Check
An investor purchased 200 shares of XYZ at $30 on March 1. She sold all 200 shares at $22 on October 15, realizing an $8-per-share loss. She repurchased 200 shares on November 5. What is the tax treatment?
The wash sale rule disallows a loss when substantially identical securities are purchased within 30 days before OR after the sale date. The sale was October 15; the repurchase was November 5 — only 21 days later, within the 30-day window. The full $1,600 loss is disallowed. The disallowed loss is added to the cost basis of the new shares: $22 + $8 = $30 new basis. When those shares are eventually sold, the embedded loss will be recognized.
Concept Check
An investor sells a long XYZ October 40 call at a $400 loss. Three days later, the investor purchases an XYZ November 40 call to maintain a similar bullish position. Under wash sale rules, the loss on the October contract is
The IRS does not consider different option series to be substantially identical securities for wash sale purposes. An XYZ October 40 call and an XYZ November 40 call have different expiration months, placing them in different series. The loss on the October contract is fully allowable despite the apparent purchase of a similar contract within the wash sale window. Same-underlying logic alone does not trigger wash sale treatment for options. There is no partial-disallowance mechanism. Loss deferral applies when a true wash sale occurs, not when the technical substantially-identical test fails.
Section 3 of 4~12 min · 4 concept checks
Gift, Estate & Inheritance Taxation
Gift Taxation: Donor Pays, Donee Inherits Basis
Gift tax has three tested mechanics: who pays, how much escapes tax each year, and what basis travels with the gift:
Who Pays
The donor is liable for any gift tax owed, not the donee. Receipt of a gift is not a taxable event for the recipient.
Annual Exclusion
Each donor may give up to the annual exclusion amount per donee per year tax-free. The exclusion is indexed to inflation and changes periodically. Married couples can elect gift-splitting to double the per-donee amount.
Donee’s Basis
The donee inherits the donor’s original cost basis — carryover basis, not stepped-up. When the donee later sells, gain or loss is computed against that carried-over figure.
Unified Credit
Gift tax and estate tax share one unified credit. Lifetime gifts above the annual exclusion eat into it; whatever is left offsets estate tax at death. The unified design closes the obvious loophole of giving everything away before dying.
Carryover basis trap:
Many candidates assume the donee’s basis equals the gift’s fair market
value at the date of transfer. It does not. The donee receives the donor’s
original cost basis. If the donor bought stock at $20 per share and gifted
it when the price was $50, the donee’s basis remains $20. Selling at
$60 produces a $40 capital gain.
Estate Taxation: Step-Up Basis Eliminates Unrealized Gain
Property transferred at death gets the tax code's best deal: the heir's basis steps up (or down) to fair market value on the date of death, and every dollar of unrealized gain from the decedent's lifetime vanishes for income tax purposes.
Worked example: A decedent purchased shares decades ago for
$10,000. At date of death, those shares are worth $250,000.
Heir’s new basis: $250,000 (stepped up from $10,000) Eliminated unrealized gain: $240,000 Tax result if heir immediately sells: No capital gain
recognized, because the sale price equals the stepped-up basis.
The estate may owe estate tax on the $250,000 transfer, but the $240,000
of unrealized appreciation that built up during the decedent’s life
escapes income taxation entirely.
The Annuity Exception
Step-up does NOT apply to
annuities. When a non-spouse beneficiary inherits a deferred
annuity, the original owner’s cost basis carries over. The accumulated
earnings inside the annuity remain taxable as ordinary income to the
beneficiary upon withdrawal. This is one of the most-tested estate-tax
exceptions on the Series 7. Standard inherited stocks, bonds, real estate,
and mutual funds all receive step-up; annuities do not.
Alternate Valuation Date
The estate may instead value everything as of six months after death, the alternate valuation date, but only if doing so lowers both the gross estate and the estate tax, and the election covers the entire estate; no cherry-picking assets.
Concept Check
A grandparent gifts publicly traded stock worth $50,000 to an adult grandchild in a single transfer. Which statement about the federal tax consequences of the gift is most accurate?
The donor of a gift, not the donee, is liable for any federal gift tax owed. Receipt of a gift is never a taxable event for the recipient at the federal level. The grandparent here would report the transfer on a gift tax return; any portion exceeding the annual exclusion is applied against the unified credit. The grandchild simply receives the stock with the grandparent’s carryover cost basis. There is no special family relationship that exempts gifts from the federal gift tax system. Splitting liability between donor and donee is not how the system functions.
Concept Check
Several years ago, a parent purchased 100 shares of stock at $20 per share. The parent gifts the shares to a child when the market price is $50. The child later sells all 100 shares at $60 per share. The child’s capital gain on the sale is
The donee inherits the donor’s original cost basis on a gift — carryover basis, not stepped-up basis. The child’s basis in the 100 shares is the parent’s original $20 per share, or $2,000 total. Sale at $60 per share yields $6,000 in proceeds, producing a $4,000 capital gain ($6,000 minus $2,000). Using the gift-date market price of $50 would be the rule for inherited (not gifted) property, incorrect here. Adding gift tax to basis is not standard treatment for typical gifts. The gift transfer does not eliminate accumulated unrealized gain — it carries over to the donee.
Concept Check
A widow inherits 1,000 shares of stock from her recently deceased husband. He had purchased the shares many years ago for $15 per share, and they were trading at $80 per share on the date of his death. The widow’s cost basis in the shares is
Inherited property receives a stepped-up basis equal to the fair market value on the date of death. The widow’s basis in the shares is $80 per share, eliminating the $65 per share unrealized gain that accumulated during her husband’s lifetime. If she sold immediately at $80, no capital gain would be recognized for income tax purposes. Using the husband’s original $15 cost would apply to gifted property, not inherited. Inherited property absolutely receives a basis. A midpoint calculation has no foundation in the tax code. The estate may owe estate tax on the transfer separately.
Concept Check
A non-spouse beneficiary inherits a deferred annuity contract that has accumulated significant earnings since the original owner purchased it. With respect to the inherited annuity, the beneficiary
Step-up basis treatment does not apply to inherited annuities. A non-spouse beneficiary inherits the original owner’s cost basis, and the accumulated earnings inside the annuity remain taxable as ordinary income when withdrawn. This is a notable exception to the general step-up rule that applies to most inherited investments — stocks, bonds, real estate, and mutual funds. Immediate forced surrender is not a generally required action for non-spouse beneficiaries, who typically may stretch withdrawals over time. The tax-free withdrawal claim contradicts the established treatment of inherited annuity earnings as ordinary income.
Section 4 of 4~8 min · 2 concept checks
DRD & 5% Markup Policy
Corporate Dividend Exclusion: The Dividends-Received Deduction
When one corporation collects dividends from another, taxing them in full would mean triple taxation: once at the operating company, again at the holding company, once more at the shareholder. The Dividends-Received Deduction (DRD) is the fix, excluding a slice of intercorporate dividends that grows with the ownership stake:
Ownership in Paying Corporation
Exclusion Percentage
Effective Tax Rate*
Less than 20%
50%
Half the corporate rate applies to the included portion
No tax on dividends from controlled subsidiary corporations
*Applied to the included (non-excluded) portion of the dividend.
Why this matters on the
Series 7: The DRD is what makes corporate-issued preferred stocks
particularly attractive to other corporations as investment vehicles.
Banks and insurance companies often hold preferred stocks of other public
companies precisely to capture the 50% (or higher) dividend exclusion,
improving after-tax yield versus other fixed-income alternatives.
The 5% Markup Policy: FINRA Rule 2121
You met the 5% policy in the disclosures chapter; this block adds the three precisions the shorthand hides: what the rule covers, what it exempts, and why 5% is not actually a ceiling.
Three Things Are Covered
Markups on principal sales to customers
Markdowns on principal purchases from customers
Commissions on agency transactions
Both principal and agency transactions are within scope.
Three Things Are NOT
Mutual fund sales (governed by Investment Company Act)
Public offerings of new issues
Exempt securities (Treasuries, certain munis)
The Limit Is Not Strictly 5%
The 5% figure is a guideline. Above it can be fair with justification; below it can be unfair without. The factors that move the line:
Markups on principal sales to customers
Markdowns on principal purchases from customers
Commissions on agency transactions
Both principal and agency transactions are within scope.
Three Things Are NOT
Mutual fund sales (governed by Investment Company Act)
Public offerings of new issues
Exempt securities (Treasuries, certain munis)
The Limit Is Not Strictly 5%
Despite the popular name, the 5% figure is a guideline,
not a strict cap. Charges above 5% may be fair if reasonably justified by
the circumstances of the trade; charges below 5% may be unfair if not
justified by the trade’s economics. Factors that affect the determination
include:
Type of security (small/illiquid securities support higher markups)
Availability of the security (hard-to-find issues justify additional cost)
Price of the security (low-priced securities frequently exceed 5%)
Total dollar amount of the transaction
Disclosure to and acceptance by the customer
Nature of the firm’s business (full-service vs. discount)
Riskless and simultaneous
transactions: When a dealer fills a customer order by immediately
buying the security from another source (a "riskless" or "simultaneous"
transaction), the markup is computed against the dealer’s contemporaneous
cost — not against an unrelated prior inventory price.
Concept Check
A corporation owns less than 20% of the common stock of another unaffiliated corporation. When the corporation receives dividend income from those holdings, what percentage of the dividends may be excluded from taxable income under the dividends-received deduction?
The Internal Revenue Code allows corporations to exclude a percentage of dividends received from other corporations through the dividends-received deduction (DRD). When the receiving corporation owns less than 20% of the paying corporation, 50% of the dividend is excluded from taxable income. Higher ownership tiers receive larger exclusions: 65% for ownership of 20% to 80%, and 100% for ownership of 80% or more. The DRD reduces what would otherwise be triple taxation of the same earnings. The 70% figure was the historical exclusion percentage before the 2017 Tax Cuts and Jobs Act adjusted it to 50%.
Concept Check
FINRA Rule 2121, commonly called the 5% markup policy, applies to which of the following types of charges?
FINRA Rule 2121 applies to all three types of compensation: markups on principal sales to customers, markdowns on principal purchases from customers, and commissions on agency transactions. The popular "5% markup policy" name obscures the breadth of what is actually covered. Both principal and agency transactions are within scope. Mutual fund sales loads, public offerings, and exempt securities such as Treasuries are explicitly outside the rule’s scope, governed by separate rules including the Investment Company Act of 1940. The 5% figure itself is a guideline rather than a strict cap.
SummaryExam Essentials — high-yield review
Chapter Summary
Ch 25 Exam Essentials — Tax Treatment of Securities Transactions
Holding period for LTCG: More than 12 months = long-term capital gain. Taxed at 0%, 15%, or 20% depending on bracket (15% for most investors in the 22%–35% brackets). Short-term = ordinary income tax rates.
Capital loss netting: First net same-type gains/losses. Then cross-netting. Net capital loss: up to $3,000/year deductible against ordinary income; excess carried forward indefinitely (retains short/long character).
Wash sale rule: Loss disallowed if substantially identical securities purchased within 30 days before OR after the sale (61-day window total). Disallowed loss added to basis of replacement shares — not permanently lost.
Qualified vs. non-qualified dividends: Qualified = taxed at LTCG rates (0/15/20%). Must hold stock 60+ days in 121-day window around ex-dividend date. REIT dividends are generally non-qualified (ordinary income).
Cost basis methods: Default = FIFO (first purchased, first sold). Specific identification allows choosing the highest-cost lot to minimize gains (must designate at time of sale). Average cost allowed for mutual fund shares only.
Cross-Cutting Tax Exam Traps — Consolidated
Twelve tax traps the exam recycles. One pass before test day; each line settles a recurring question:
1. Donor pays gift tax, not donee. Receipt of a gift is
never a taxable event for the recipient. The donor reports gifts above the
annual exclusion against the unified credit.
2. Donee inherits donor’s cost basis (carryover). Not
fair market value at date of gift. If donor bought at $20 and gifted at
$50, donee’s basis is $20.
3. Inherited property gets stepped-up basis to FMV at date of
death. Eliminates accumulated unrealized gain for income tax
purposes. Potential estate tax owed at death is separate.
4. Step-up does NOT apply to inherited annuities. The
non-spouse beneficiary inherits the original owner’s cost basis.
Accumulated earnings remain taxable as ordinary income on withdrawal.
5. Unified credit links gift and estate taxes. Lifetime
gifts above annual exclusion deplete the credit; remainder applies against
estate tax at death.
6. Corporate dividend exclusion: 50% / 65% / 100%. Based
on ownership: under 20% = 50%, 20-80% = 65%, 80%+ = 100%. Reduces
intercorporate triple taxation.
7. FINRA Rule 2121 applies to markups, markdowns, AND
commissions. Both principal and agency transactions covered.
Mutual funds, new issues, and exempt securities are excluded.
8. The 5% figure is a guideline, not a strict cap. Higher
charges may be fair if circumstances justify; lower charges may be unfair
if economics do not support them.
9. Wash sale window = 30 days before + 30 days after = 61 days
total. Includes the trade date itself. Applies to realized losses
only, not to realized gains.
10. Different option series are NOT substantially identical.
An XYZ Oct 40 call and an XYZ Nov 40 call are different series; selling
one at a loss and buying the other does not trigger wash sale.
11. Bond swap avoids wash sale with one differentiator.
Different issuer, maturity, OR coupon. Common tax-loss harvesting strategy
that maintains fixed-income exposure.
12. Disallowed wash sale loss adds to replacement basis.
Loss is deferred, not eliminated. Recovered when the replacement security
is later sold without triggering another wash sale.