Most people are used to paying income taxes on regular income from their jobs. However, many people get confused when it comes to paying capital gains taxes on stock trades.
There are no taxes due from buying stocks. In fact, if you held your stocks for the rest of your life, you would never have to pay anything to the government. Taxes only enter the picture when you sell.
At that point, it gets a little tricky. Your broker will then send the IRS a statement showing the proceeds of the sale. It is then important for you to determine the cost basis of those shares - i.e, the price and date that you bought the particular shares you just sold. The cost basis is needed to determine whether you have a gain or loss, and whether the gain/loss is long term or short term.
A long term gain or loss occurs when you have held the stock for at least a year and a day. If you held the stock less than a year and a day, it is a short term gain / loss. This is important because long term gains are taxed at a lower rate than short term gains. This is because the government likes to encourage long term investments, because they create jobs.
If you do not provide a cost basis on your tax return, the IRS will assume you bought the stock for $0 and it was a short term gain. This can cost you a lot of money!
For example, suppose that, in one year, you bought 1,000 shares of GE for $34, sold them for $32, and then used some of the money to buy 1,000 shares of HP for $20. Finally, you sold the HP shares for $22. You have broken even - you lost $2,000 on GE and gained $2,000 on HP.
However, the IRS will get a statement from your broker that you sold $32,000 of GE and $22,000 of HP. If you do not provide a cost basis on your tax return, the IRS will think you earned $54,000! They may come after you for back taxes and interest.
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