When a security is sold in a taxable account, the seller (or the tax preparer) must compute the gain or loss to figure the tax due.
Until recently, it has been the responsibility of the taxpayer to track the cost basis, a task that is complicated by splits, reinvestments and difficulty locating purchase records for long-held positions.
Beginning in January 2011, a new law took effect requiring custodians to maintain cost data. For purchases made after the effective date, broker-dealers and fund companies must track the adjusted cost basis, report the data to the Internal Revenue Service and convey the information to another broker if the account is transferred.
Investors should understand the requirements and make decisions to minimize their tax liability.
According to a 2005 IRS study, inaccurate or fraudulent reporting of cost basis information results in an $11 billion annual loss in revenue to the federal government.
In an effort to close the tax gap, Congress inserted a provision in the 2008 Emergency Economic Stabilization Act (the TARP bill) requiring custodians to begin tracking cost data. Implementation of the requirements is phased in over three years, beginning with individual stocks in 2011.
Mutual funds, ETFs, and direct reinvestment plans will commence reporting in 2012, while options and bonds fall under the rules in 2013. IRAs, 401(k)s and other retirement accounts are exempt.
For anyone who has wrestled with reconstructing the basis for a stock that has been through multiple splits, this is welcome news. The new rules require issuing companies to furnish documentation to the broker and the investor explaining the effect of corporate actions such as splits, mergers and spinoffs.
Adjusted cost basis data will then be reported to the IRS, and appear on investors’ form 1099-B.
While the reporting of gains and losses will be greatly simplified, there are potential tax consequences for shareholders who sell part of their positions if they were purchased at different prices.
Heretofore, taxpayers identified tax lots at the time they filed their returns. For example, suppose last year you purchased 100 shares of Coke at $60 per share and another 100 shares at $70. You then sold 100 shares at $65 this December. Under the old rules, you could chose when preparing your return whether to realize a gain or loss by specifying which lot to sell.
In the future, brokerages and mutual funds will select tax lots according to their declared default method, unless you notify them before the trade settles. The broker then reports the gain or loss, and characterizes it as short-term or long-term.
You may give your broker standing instructions for handling tax lots, and you may override the instructions on any particular trade as long as you do so prior to settlement.
For most investors who trade infrequently, the benefits of the new reporting rules will far outweigh the minimal disadvantages. More active investors will want to understand the provision and actively manage their tax lot instructions to minimize their capital gains taxes.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfree press.com.