By David Peartree
The Daily Record Newswire
It's time for investors to get serious about cost basis, if for no other reason than the IRS finally is.
Cost basis, in simple terms, is what an investor has paid for an investment. The original cost basis is then adjusted for subsequent purchases or sales, as well as for reinvested dividends and capital gains. Then there are stock splits, commissions, fees and other possible adjustments. This is principally an issue with taxable investments, not IRAs or other retirement accounts.
For many years, reporting gains and losses to the IRS essentially has been a matter of voluntary compliance. A brokerage firm or investment custodian (for ease of reference, "brokers") would report the proceeds from an investment sale, but not the resulting gains or losses. It fell to the investor to properly report realized gains or losses on the tax return, including whether short- or long-term.
This arrangement left investors solely responsible for maintaining records of their investment transactions sufficient to track their cost basis and then reporting their gains and losses. The problem has been that too many investors have been casual in their recordkeeping, if not entirely oblivious to the issue.
Many brokers have been tracking cost basis for some time, but it's been hit or miss. Moreover, if the data is lost for some reason, such as a merger with another investment company or a change in the account registration, you are on your own. Until now, the cooperation of brokers keeping track of cost basis has been a customer courtesy only.
Cost basis is so critical because it tells you where you stand as an investor and as a taxpayer. If you don't know the cost basis of your investments, you can't determine your gains and losses and it becomes difficult to make intelligent decisions about which investments to keep and which to sell.
Of more concern to the IRS, in a system based on self-reporting, they can't tell, short of an audit, if you are meeting your obligation as a taxpayer. Well, the era of voluntary compliance is coming to an end.
We are shifting to a mandatory reporting system as the result of the Emergency Economic Stabilization Act of 2008. Phase one took effect in 2011 and requires brokers to report to the IRS the cost basis of stocks sold. Phase two takes effect Jan. 1, 2012, and imposes similar reporting requirements with respect to mutual funds, exchange-traded funds (ETFs) and dividend reinvestment plans (DRIPs).
These changes appear to shift all responsibility for cost basis reporting to brokers and away from investors. Not so. Plenty of responsibility still falls on the investor.
Here are five keys things you should know.
1. Not all securities are covered. Brokers are only required to report cost basis for "covered" securities. This means equities acquired on or after Jan. 1, 2011, and mutual funds, ETFs, and dividend reinvestment programs acquired on or after Jan. 1, 2012. (A third phase covering fixed income and options will take effect in 2013.) For securities acquired before these dates, brokers have no reporting responsibilities. That obligation still falls to the taxpayer.
2. The timing for choosing a cost basis method has changed. Under the old regime, investors did not have to worry about cost basis until they sold the investment and filed their tax returns. That might be years or decades after the purchase. Now, the cost basis method needs to be selected when the investment is purchased. The election cannot be changed after the trade settles.
3. You can choose a cost basis method, or the IRS will choose for you. The IRS offers several methods for calculating cost basis. Going forward, if you don't make an express election at the time of purchase, the IRS will assign a default method. First in, first out is the default for equities. Average cost is the default for mutual funds, ETFs and DRIPs. You need to think about this at the time of purchase. Once the trade settles, it's too late.
4. Make sure you are getting the same information the IRS will receive. Many advisory firms track and report cost basis to their clients. It's the broker's cost basis data that matters, however. There are at least five cost basis methods to choose from: first in, first out; last in, last out; high cost and low cost. For mutual funds, ETFs and DRIPs, average cost is an additional option. It's the broker's data that gets reported to the IRS, so make sure that your own data or your advisor's is consistent with the method being used by your broker and the data being reported to the IRS.
5. Form 1099-B has changed and will likely cause confusion. Starting in 2012 and covering the 2011 tax year, Form 1099-B has been thoroughly revised and enhanced. New information being reported includes cost basis, covered v. uncovered status, acquisition date, and whether gains are short- or long-term.
As a courtesy to their clients, brokers may choose to report cost basis for uncovered securities (those purchased before the legislation's effective dates) on the 1099-B. While that's nice, it creates the following dilemma for investors who use the average cost method, a very common method for mutual fund investors.
A mutual fund may end up with two average costs -- one for the uncovered shares and one for covered shares. This can happen if an investor owns fund shares not covered by the legislation and then buys additional shares after the effective date.
The new legislation is a boon to the IRS but it should also prove beneficial to investors, provided they know their responsibilities and remember that the ultimate responsibility for reporting investment gains and losses always falls to the taxpayer.
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David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, N.Y. 14625, or email david@worthconsidering.com.
Published: Tue, Nov 22, 2011
