From Schweser practice exam, Vol 2 Question 46. (you don’t need any info from the vignette to solve this one)

Assume that Vance sells some of his TTT stock. The pretax return on the TTT stock averaged 12% per year over 10 years , the capital gains tax rate is 35% and the cost basis is $250,000. What is the after tax gain on the investment?

A. $254,200 B. $342,200 C. $592,200

My question is, since he has invested the stock for 10 years, wouldn’t B not equal to 1? I thought B was cost basis/value of the position beginning period n, and we are in period 10?

The correct answer is B. $342,200 using the capital gain tax formula assuming B is equal to 1.

B – the tax basis of the original investment – would be less than one only if there were some portion of the original investment that hadn’t been taxed previously (i.e., before the beginning of this investment). Do you have evidence to lead you to suspect that that’s the case here?

The definition of cost basis is the portion of the original investment that is not subject to additional tax. If B < 1, then some portion of the original investment is subject to tax _ from a prior transaction _.

For example, in the US Tax Code there is §1031, Like-Kind Exchanges. If you exchange one asset for another asset of a like kind (as defined in the section), then you can defer the taxes on the exchanged property. Suppose that you bought a house for $100,000 many years ago and by last year it had appreciated to $1,000,000 in value. You exchange it for an apartment building worth $1,000,000 and that investment then earns a 10% return per year for 5 years, growing to $1,610,510 in value, whereupon you sell it. Your tax will be not only on the $650,510 gain that you made on this investment, but also on the $900,000 in previously untaxed gain; B = 0.1 in this case, because 10% of the original $1,000,000 is not subject to tax (your original $100,000 investment many, many years ago), but the other 90% of the original $1,000,000 investment (the gain on the $100,000 investment between the time you purchased the house and the time you exchanged it) is subject to tax (because it wasn’t taxed before this investment began).