A major change to the “cost basis” reporting rules recently kicked in regarding the amount of information that is supplied to the IRS about investors’ activities.
Up until 2011, the burden for determining the cost basis of securities transactions for income tax purposes was shouldered by taxpayers. In other words, the IRS was informed about how much investors sold securities for, but the agency relied on investors to provide the purchase prices.
Tax officials long suspected that many taxpayers overstated their cost basis in order to pay less tax. In response, the U.S. Treasury Department pushed for legislation that would require cost basis reporting by investment firms.
The Emergency Economic Stabilization Act of 2008 revised the rules for certain securities. Under the new rules, which are being phased in over three years, brokers are required to report the cost basis information to investors on Form 1099-B issued after the close of the year. This should make it easier for investors to figure out the tax consequences of the sale of investments.
The effective dates for acquisitions are:
• Jan. 1, 2011, for stocks (including domestic and foreign stocks), American Depository Receipts, real estate investment trusts and exchange-traded funds (ETFs) that are taxable as corporations. ETFs in this category generally are treated as mutual funds.
• Jan. 1, 2012, for mutual fund and dividend reinvestment plan shares.
• Jan. 1, 2013, for all other remaining securities, including options, fixed income instruments and debt instruments.
In other words, if you buy and sell stock or mutual funds in 2012, the Form 1099 you’ll receive next year will reflect the vital cost basis information for these transactions. That information will be used to compute your tax liability on the 2012 return you must file by April 15, 2013.
Of course, when the tax laws change, there can be other implications. The reporting change can simplify your life — you won’t have to comb through paperwork to find the cost basis of covered securities purchased long ago. However, it may also eliminate some tax-saving opportunities.
Under the new rules, you must select a cost basis determination method for each transaction. If you don’t select a method, the first-in, first-out (FIFO) method will be used as a default for most securities, although brokers can elect to use the average cost basis method as the default for mutual funds. (See “6 cost basis methods” below.)
You no longer can defer these decisions until tax return time. After the settlement date, no changes are permitted. Therefore, if you subsequently find that choosing a different method would have produced an advantage for your particular tax situation, it will be too late.
And there’s another level of complexity. The new rules apply only to investments acquired by the previously mentioned effective dates. For investments acquired before those dates, you must continue to provide the purchase prices and the gain or loss calculations. Although brokers may voluntarily provide the information for investments acquired before the effective dates, they’re under no legal obligation to do so.
The bottom line is that you can expect the “old” and “new” rules to exist side-by-side for years. Even the simplified rules could present challenges on your tax return. Consult with your tax advisor for guidance in your personal situation.
6 cost basis methods
There are six cost basis methods for investors that could provide varying tax results:
1. First-in, first-out (FIFO). The first shares you acquired are treated as the first shares sold. Assuming the shares have appreciated in value over time, this method may produce a large taxable gain, although results naturally vary.
2. Last-in, first-out (LIFO). In this case, the shares you acquire last are treated as the first ones sold. Usually, this produces a smaller gain than the FIFO method, but exceptions can occur. On the other hand, because the shares were the last ones purchased, this method might result in short-term gains as opposed to long-term gains.
3. Highest cost. The shares you sold are assumed to be the ones that have the highest cost basis, regardless of when you acquired them. This method will harvest the biggest losses first, and then gains ranging from the smallest to largest, although some of those gains may be short-term gains.
4. Lowest cost. This is the opposite of the highest cost method. It assumes the shares you sold first are those with the lowest cost, regardless of the holding period or date of acquisition. Accordingly, using the lowest cost method maximizes the amount of gains realized and minimizes losses.
5. Average cost. For mutual funds, the broker may add up the total cost basis and divide by the total number of shares to determine the average cost for each share. This method generally simplifies cost accounting and smooths out gains and losses realized from year to year. However, if an investment is prone to volatility, the average cost method may provide less tax flexibility.
6. Specific lots. This method allows you to choose a specific lot at the time of sale. However, it creates some extra work because you have to pay close attention to each transaction. On the positive side, choosing a specific lot at the time of sale ensures that you will benefit from the optimal tax approach for your situation at that time.
Paul Bendik, CPA, is a Shareholder at CSH and can be reached at [email protected]