Stock Splits: Are Two Halves Better than the Whole?

It usually isn’t a good thing for investors when the price of their stock is cut in two. But it may be a positive event when your stock splits. In that case, your shares are worth half of their previous value — but you now own double the amount of shares.

In other words, a stock split is like giving a cashier a twenty-dollar bill and getting back two tens in return.

Practically speaking, there’s no initial economic change when your stock splits. However, it may provide a psychological lift, since investors often feel they can benefit from a lower stock price. For example, 100 shares of a stock at $5 a share may seem like a better deal to you than 50 shares at $10 a share.

In addition, stocks are often known to increase in value prior to a split or soon thereafter. A stock split may be an indication of positive news for the company, such as expansion of anticipated growth. Caveat: Due to the potential volatility of the stock market, there are no absolute guarantees.

Although you don’t have to pay any income tax when a stock splits, you must adjust your basis accordingly. In our example above, the owner of stock with a basis of $10 a share must adjust his or her basis to $5 a share when the stock splits.

Note that a “reverse split” is the opposite of a traditional stock split. In this case, you end up with half the number of shares at double the price. For example, if you own 10,000 shares of a company and it declares a one for ten reverse split, you will own a total of 1,000 shares after the split. Some reverse stock splits cause small shareholders to be “cashed out” so that they no longer own the company’s shares.

What About Taxes?

Although the split itself doesn’t increase the value of your investment, it could make a big difference in your tax bill you when you trade the shares later on.

That’s why when you sell shares of stock after a split, make sure you can tell the IRS which shares you’re selling and when you originally purchased them. If you don’t keep accurate records, you might pay too much tax on your profit.

Assume that, a few months ago, you bought 2,000 shares of stock in a Company A for $10 a share. The company has just announced a two-for-one split. That means you now own 4,000 shares with a basis of $5 a share.

A few months after the split, the stock price starts to rise. You buy another 500 shares at $8 a share. Shortly thereafter, you sell 500 shares at $9 a share.

So what is your taxable gain? Is it $1 per share? It depends. Unless you specify otherwise, the IRS will assume that the shares you’ve sold are the original shares you purchased. In that case, your taxable gain is $2,000, or $4 per share ($9 sale price less $5 basis after the split). If you prefer to let the original shares grow in value, tell the IRS that you are selling the shares you purchased most recently. You’ll have to record the stock certificate numbers in chronological order and give written instructions to your broker.

For all the ramifications of traditional stock splits and reverse splits, consult with your financial advisor.