Taxation Basics for the SIE: Basis, Holding Periods, and Wash Sales

Most tax explainers open with a rate table. The SIE never asks you for one.

Capital gains rates, bracket thresholds, contribution limits — they change with legislation and inflation adjustments, and FINRA doesn’t build exam questions on numbers that move every year. What the exam tests is treatment: which income is taxed how, when a gain counts as long-term, what happens to your cost basis, and which securities escape which layer of tax.

Those rules are structural and stable. Learn them once and they hold.

The short answer

Cost basis is what you paid, including commissions. Gain or loss is sale proceeds minus basis.

Holding period decides the character of a gain. Held more than one year — long-term. One year or less — short-term, taxed as ordinary income. The clock starts the day after the trade date.

Capital losses offset capital gains first. Anything left over offsets up to $3,000 of ordinary income per year, and the rest carries forward indefinitely.

The wash sale rule disallows a loss if you buy the same or a substantially identical security within 30 days before or after the sale. The loss isn’t gone — it’s added to the basis of the replacement shares.

Dividends are either qualified (taxed at long-term capital gains rates) or ordinary (taxed as income). The difference turns on a holding period, not on the company.

Interest is taxed as ordinary income, with two big exceptions: municipal bond interest is exempt from federal tax, and Treasury interest is exempt from state and local tax.

The full answer

Cost basis

Basis is the starting point for every gain or loss calculation. For a straightforward purchase it’s the price paid plus commissions and fees. On the sale side, commissions reduce the proceeds.

Buy 100 shares at $40 with a $10 commission: basis is $4,010. Sell them at $55 with a $10 commission: proceeds are $5,490. Gain is $1,480.

Basis gets adjusted over time in ways the exam likes:

Event	Effect on basis
Reinvested dividends	Increase basis — you already paid tax on them
Return of capital distribution	Decreases basis — not taxed now, but raises the eventual gain
Stock split	Total basis unchanged; basis per share falls
Stock dividend	Total basis unchanged; spread across more shares
Wash sale	Disallowed loss added to the replacement shares’ basis

The reinvested-dividends row is where people double-pay. A dividend you reinvested was taxed in the year you received it. If you forget to add it to basis, you’re taxed on it again when you sell.

Which shares did you sell? When you’ve bought the same security at different prices, the method matters:

• FIFO — first in, first out. The default if you don’t specify
• Specific identification — you choose which lots to sell, typically the highest-basis ones to minimise the gain
• Average cost — available for mutual fund shares

Inherited versus gifted securities

Two ways of acquiring a security without buying it, with opposite basis rules.

Inherited: basis steps up to fair market value at the date of death. Decades of unrealised gain disappear for tax purposes. And the holding period is automatically long-term, regardless of how long the heir actually held it.

Gifted: the recipient generally takes the donor’s basis — a carryover. The embedded gain comes along with the gift.

This is why the same appreciated stock is far better inherited than gifted, from the recipient’s tax perspective. It’s also a reliable exam question.

Holding period

More than one year is long-term. One year or less is short-term.

The clock starts the day after the trade date — not the settlement date. Buy on March 10 and you need to sell on March 11 of the following year or later for the gain to be long-term.

Short-term gains are taxed as ordinary income, at the same rates as wages. Long-term gains get preferential rates. The exact rates aren’t tested; the distinction is.

Capital losses

Losses are netted in a set order:

1. Short-term losses offset short-term gains; long-term losses offset long-term gains
2. Any net loss in one category offsets net gain in the other
3. A remaining net capital loss offsets up to $3,000 of ordinary income per year ($1,500 if married filing separately)
4. Anything beyond that carries forward indefinitely, keeping its short- or long-term character

The $3,000 figure has been unchanged since 1978 — one of the few tax numbers stable enough to be worth memorising.

The wash sale rule

Sell a security at a loss, then buy the same or a substantially identical security within 30 days before or after the sale, and the loss is disallowed.

That’s a 61-day window: 30 days before, the day of sale, and 30 days after. People forget the “before” half. Buying more shares a week before selling your losing lot also triggers it.

The part most guides get wrong: the loss isn’t lost. It’s added to the cost basis of the replacement shares, and the holding period of the original shares carries over too. The rule defers the loss rather than destroying it — you recover it when you eventually sell the replacement position.

Three details worth holding:

• It applies to losses only. Selling at a gain and buying back immediately triggers nothing
• Buying call options on the same stock within the window counts as acquiring it
• Buying in an IRA within the window still triggers the rule — and there the disallowed loss can be permanently lost, because basis doesn’t carry into the IRA

Dividends: qualified versus ordinary

Qualified dividends are taxed at long-term capital gains rates. Ordinary (non-qualified) dividends are taxed as ordinary income.

For a dividend to be qualified, two things must be true:

1. It’s paid by a US corporation or a qualified foreign corporation, and
2. You held the stock more than 60 days during the 121-day period that begins 60 days before the ex-dividend date

Buying a stock the day before the ex-date to collect the dividend, then selling, gets you an ordinary dividend. That’s by design — the holding requirement exists to stop exactly that trade.

Some distributions are never qualified: most REIT dividends and interest-driven distributions from bond funds, for example.

Interest: the two exceptions that matter

Interest is ordinary income by default. Two securities break the rule, and they break it in opposite directions.

Security	Federal tax	State and local tax
Corporate bond interest	Taxable	Taxable
Municipal bond interest	Exempt	Exempt in the issuing state; generally taxable elsewhere
Treasury interest	Taxable	Exempt

A municipal bond bought by a resident of the issuing state can be triple tax-free — federal, state and local.

Two traps:

Municipal capital gains are taxable. The exemption covers the interest. Buy a muni at a discount and sell it for more, and the gain is taxable like any other capital gain.

Treasury exemption is state-level only. Treasuries are fully taxable at the federal level. The benefit is only against state and local income tax, which matters most to investors in high-tax states.

Mutual fund distributions

Funds pass their income through to shareholders, and each type keeps its character:

• Dividend distributions — qualified or ordinary, depending on the underlying holdings
• Capital gain distributions — always long-term, regardless of how long you held the fund shares
• Taxable even when reinvested — reinvesting doesn’t defer the tax; it just increases your basis

The third point surprises people. You can owe tax on a fund you never sold and never took cash from, because the fund realised gains inside the portfolio and distributed them to you.

How other structures fit in

Posts elsewhere on this site cover these in depth; the tax treatment in one line each:

• DPPs — flow-through. Income and losses pass straight to partners, and losses are passive
• REITs — distribute most of their income; distributions mostly taxed as ordinary income
• Qualified retirement plans — zero cost basis, so distributions are fully taxable as ordinary income
• Roth IRAs — qualified distributions tax-free
• Variable annuities — tax-deferred growth; earnings taxed as ordinary income on withdrawal, with LIFO treatment, so earnings come out first

Backup withholding

If a customer fails to provide a correct taxpayer identification number, or the IRS notifies the firm of under-reporting, the broker-dealer must withhold 24% of reportable payments — interest, dividends, and sale proceeds — and remit it to the IRS.

What the SIE doesn’t test

It’s worth being explicit, because study material pads this topic:

• Capital gains rate tables and income thresholds
• Ordinary income brackets
• IRA and 401(k) contribution limits
• Detailed calculation of accrued interest or OID accretion

These change, and the exam avoids them. If a practice question asks you to recall a specific bracket, it’s miscalibrated.

Common misconceptions

“The wash sale rule means you lose the loss.” It’s deferred, not destroyed. The disallowed loss is added to the replacement shares’ basis.

“The wash sale window is 30 days after the sale.” It’s 30 days before and after — a 61-day window.

“Long-term means one year.” It means more than one year. Exactly one year is still short-term.

“The holding period starts on settlement.” It starts the day after the trade date.

“Municipal bonds are completely tax-free.” The interest is federally exempt. Capital gains on munis are taxable, and interest from out-of-state munis is usually taxable at the state level.

“Treasury interest is tax-free.” It’s exempt from state and local tax. It’s fully taxable federally.

“Inherited stock keeps the original owner’s basis.” That’s the rule for gifts. Inherited securities get a step-up to fair market value at death.

“Reinvested dividends aren’t taxable.” They’re taxable in the year paid. Reinvesting just adds them to your basis.

“Mutual fund capital gain distributions depend on how long I held the fund.” They’re always long-term.

“Capital losses can offset unlimited income.” Beyond capital gains, only $3,000 of ordinary income a year. The rest carries forward.

What to do with this info

1. Learn treatment, not rates. If you’re memorising a bracket table, you’re studying for a different exam.
2. Anchor on basis. Most tax questions reduce to what the basis is and what just happened to it.
3. Drill the two interest exceptions as a pair — munis federal-exempt, Treasuries state-exempt. They’re tested as opposites.
4. Remember “before and after” on wash sales, and that the loss moves into the new basis.
5. Contrast inherited and gifted. Step-up versus carryover is one of the cleanest questions on the exam.
6. Take a domain-scored diagnostic. Tax treatment runs through the 44% products domain — a weak spot here shows up in questions that look like they’re about something else.

Related resources

• Retirement and education accounts — qualified versus non-qualified, and why cost basis decides distribution tax
• Municipal bonds: GO vs revenue — the securities behind the federal interest exemption
• Treasury and government securities — where the state tax exemption applies
• Direct participation programs — flow-through taxation and passive losses
• Dividend dates: the DERP method — the ex-date that anchors the qualified dividend holding period
• Every number and formula on the SIE — the wash sale window and backup withholding rate in one reference
• Corporate actions: splits, tender offers and rights — what a split does to your open orders, and the tender offer rules
• Free SIE practice exam — a domain-scored diagnostic