If you've spent any time reading my tax articles or visiting the Tax Strategies discussion board, you've certainly come across the term "holding period." The holding period of virtually any asset is an important concept that you'll want to understand in order to make smart tax choices.

Calculating the length of time you've held an asset is a fundamental component of the tax treatment of capital gains and losses. This is because the capital gain and loss provisions of the Internal Revenue Code distinguish between short-term and long-term gains and losses. Correctly classifying gains and losses is essential to correctly calculating your net capital gains or losses. That's why the holding period is so important.

As you likely already know, long-term gains are taxed at lower rates than short-term gains or ordinary income. Under the current law, an asset has a long-term holding period if it has been held, or is deemed to have been held, for more than one year.

To compute the holding period of property, you begin counting on the day after the date you acquired the property and stop counting on the day that you dispose of it. But you don't merely count out 365 days. Instead, you use that first day as a benchmark for each succeeding month. You then use that benchmark to determine your sale date and your ultimate holding period. If you've held the property for more than one year, your gain or loss is a long-term capital gain or loss. If, on the other hand, you've held the property one year or less, your capital gain or loss is short-term.

For example: Lorna bought 100 shares of stock on Jan. 1, 2005. To determine her holding period, she should start counting on Jan. 2, 2005. The second day of each month thereafter counts as the beginning of a new month, regardless of how many days each month contains. If she sells the property on Jan. 1, 2006, her holding period will be one year or less and she will realize a short-term capital gain or loss. If, on the other hand, she sells the property on Jan. 2, 2006, her holding period will have been one year and a day, and she will realize a long-term capital gain or loss. See how it works?

This might seem easy on first blush, but it can get a bit tricky. Various assets that you purchase or acquire will have odd holding periods according to the law. Here are some examples of investment property and the specific rules for calculating holding periods that apply to each:

Securities traded on an established market:
For these, the holding period begins the day after the trading date on which you buy the securities and ends on the trading date on which you sell them. You ignore the settlement date for holding-period purposes. The trade date controls the transaction. The trade date is the date on which the transaction occurs. Settlement dates, usually a few days after the trade date, represent when payment must be made for a purchase or when assets must be delivered for a sale.

If you acquire new investment property in exchange for old investment property (such as in a tax-deferred exchange), the holding period begins on the day after the date the original (or old) property was acquired. So, if you exchange or trade a beachfront lot that you bought in May 1999 and use the proceeds to buy a cabin in the mountains in 2005, your holding period for the mountain cabin begins on the day after the date you bought the beachfront lot, all the way back to May 1999.

Real estate:
If you purchase real property under an unconditional contract, you begin counting on the day you received title to the property or the day after you took possession and assumed the incidents of ownership, whichever is earlier. Taking delivery or possession of real property under an option to purchase, however, is not enough to start the holding period. The holding period cannot start until there is an actual contract of sale. Likewise, the holding period of the seller cannot end before that time.

If you receive a gift of property and your cost basis in the gift is figured by using the donor's basis (such as in the gift of appreciated stock), then your holding period includes the donor's holding period. This is known as "tacking on" the holding period. Why? Because your holding period "tacks on" to the original donor's holding period. If, however, your basis in the gift is determined by the fair market value of the gift (such as with a gift of stock that has decreased in value), your holding period starts on the day after the date of the gift.

Inheritance:
If you inherit investment property, your gain or loss on any subsequent disposition of such property is generally treated as a long-term gain or loss regardless of how long you may have actually held the property. This being the case, you are considered to have held the inherited property for more than one year even if you dispose of the property within one year of the decedent's death.

For example, let's say your Aunt Bernice passed away in March 2004 and left you 100 shares of stock. After the estate was settled in June 2004, you were given those shares in your name. You turned around and sold the shares in July 2004. Even though you held the shares for less than a year, you are able to treat them as though you held them for a long-term period. So your gain or loss on these shares would be a long-term gain or loss to you. This is true regardless of how long Aunt Bernice may have held the shares before she passed away.

Stock splits and spinoffs:
If you receive a stock dividend, your holding period for the "new" shares is the same as for the "old" shares. This is also true if you receive new stock in a company that has been spun off from the original company that you purchased.

For example, Jack purchased 100 shares of stock in April 1999. In June 2000, the company declared a 100% stock dividend (also known as a 2-for-1 stock split). Jack now has 200 shares of the company stock, but they all have the same holding period -- the date of original purchase back in April 1999.

Here's another example. Using the same facts as above, let's assume that instead of declaring a stock dividend, the company instead spun off a subsidiary. Jack receives an additional 30 shares of the new company in June 2002. Even though these are brand-new shares in a brand-new company, they will have the same holding period as the original shares that were purchased back in April 1999.

There are other tricks and turns regarding holding periods. These are only the common rules, and by no means cover every holding period situation. So, if you find yourself in the middle of an unusual transaction, check the holding period rules carefully. The tax dollars you save might be your own.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.