Become Familiar with New Cost Basis Rules When Reporting Stock Sales: Maloney + Novotny Certified Public Accountants

Become Familiar with New Cost Basis Rules When Reporting Stock Sales

The new "cost basis" reporting rules for investments may have an impact on your 2011 tax return ... finally.

Background: 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 tax 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 Treasury Department pushed for legislation that would require cost basis reporting by investment firms.

The Emergency Economic Stabilization Act revised the rules for certain securities. Under the 2008 law, which is being phased in over three years, brokers are required to report the cost basis information to investors on the Forms 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 as follows:

January 1, 2011 for stocks (including domestic and foreign stocks), American Depository Receipts, real estate investment trusts (REITs) and exchange-traded funds (ETFs) that are taxable as corporations. ETFs in this category are generally treated as mutual funds.
January 1, 2012 for mutual fund and dividend reinvestment plan (DRP) shares.
January 1, 2013 for all other remaining securities, including options, fixed income instruments and debt instruments.

In other words, if you bought and sold a domestic or foreign stock in 2011, the Form 1099 you'll receive this year will reflect the vital cost basis information for this transaction. That information will be used to compute your tax liability on the 2011 return you must file by April 17, 2012.

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.

Here's why: 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 right-hand box).

You can't defer these decisions until tax return time any longer. 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 only apply to securities acquired by the effective dates shown above. 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 securities acquired before the effective dates, they're under no legal obligation to do so.

Bottom line: 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 adviser for guidance in your personal situation.

Six Cost Basis Methods

There are six cost basis methods for investors that could provide varying tax results. They are:

1. First-in, first-out (FIFO) - The firstshares 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 that were acquired 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 - With the highest cost method, shares that are sold are assumed to be the ones that have the highest cost basis, regardless of when they were acquired. 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. Naturally, this is the opposite of the highest cost method. It assumes that the shares with the lowest cost are sold first, 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. 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.