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Private Wealth - Exam Question

Wald has a realized capital gain of CLC 50,000 in another taxable account. Her advisor reviews that account and notices that Stock Y has an unrealized loss of CLC 45,000 and a cost basis of CLC 220,000. The advisor explains two alternate plans to Wald:

Plan A: Sell Stock Y in Year 1 to realize the loss and replace it with Stock Z, which the advisor believes will have the same expected return as Stock Y. In Year 2, sell Stock Z at an expected market value of CLC 250,000.

Plan B: Hold Stock Y until Year 2 and then sell it at an expected market value of CLC 250,000. B.

Demonstrate that the amount of Wald’s total two-year tax liability is the same for both plans. Show your calculations.

Could someone please explain the rationing that should be applied in such a case, with the replacement of stocks with same returns? I have seen the solution, but do not really get it… 

Thank you, I would appreciate it very much, I got very frustrated because of this :(

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CaliforniaDreaming wrote:

Could someone please explain the rationing that should be applied in such a case, with the replacement of stocks with same returns? I have seen the solution, but do not really get it… 

Don’t focus on this. They’re only using that as an example to make a point. Just look at the tax bill the client pays each year under both options.

assuming 20% cap gains:

Plan A
Year 1 tax bill: 1,000
Year 2 tax bill: 15,000
Total: 16,000

Plan B
Year 1 tax bill: 10,000
Year 2 tax bill: 6,000
total: 16,000

¯\_(ツ)_/¯ It be like that sometimes.

I would have 2 questions.

Why is actually the unrealized loss deducted from your cost basis (Plan A, year 2?)

Why isn’t the realized loss applied for Plan B, Year 2? (you are selling the security, why is your loss not realized?)

Many thanks

CaliforniaDreaming wrote:

Why is actually the unrealized loss deducted from your cost basis (Plan A, year 2?)

Because in Plan A you’re REALIZING the loss. Which means, the investment you PAID $220,000.00 for is now only worth $175,000.00. You REALIZE a $45,000.00 loss to offset against your $50,000.00 gain. The $175,000.00 is then reinvested in a different security, then finally grows to $250,000.00 in year 2. 

CaliforniaDreaming wrote:

Why isn’t the realized loss applied for Plan B, Year 2? (you are selling the security, why is your loss not realized?)

In plan B - there is no loss ever realized. It’s non-existant. 

¯\_(ツ)_/¯ It be like that sometimes.

All clear for plan B, thank you.

If I may ask you one more thing - for plan A, year 2 - my question of “why are we deducting the realized loss from the cost basis” was referring to the fact that we already deducted it in year 1. So, in year 2, we apply this deduction of 45,000 again - why? Many thanks, this is much appreciated. 

CaliforniaDreaming wrote:

All clear for plan B, thank you.

If I may ask you one more thing - for plan A, year 2 - my question of “why are we deducting the realized loss from the cost basis” was referring to the fact that we already deducted it in year 1. So, in year 2, we apply this deduction of 45,000 again - why? Many thanks, this is much appreciated. 

Once you buy the new stock, you have a new cost basis, which is $45k below the old cost basis. So, when you sell the investment at $250K, you have a $75K realized GAIN since your cost basis is now $175k. 

You might go try trading a couple stocks in real life to familiarize yourself with this better. 

¯\_(ツ)_/¯ It be like that sometimes.

Thank you very much for taking your time!