By: John Pitlosh
By: John Pitlosh, CFP®, MST
Between January 2011 and January 2013 brokerage firms everywhere will start reporting investor gains and losses for new holdings directly to the IRS. Whenever a new law requires someone else to report information about you directly to the IRS you might want to review whats going on.
Fortunately, the new reporting requirements being added to everyones 1099-B starting in tax year 2011 will have a mostly positive impact on investors. The new law will make investors lives easier during tax time because it will shift a large portion of cost basis bookkeeping from individuals over to brokerage firms.
Next year should also serve as a wake up call for investors to review and be proactive about what cost basis method they are using to track their adjusted cost basis. Investors that arent proactive could end up with IRS default methods for tracking their cost basis. In general, IRS default methods are either inflexible or they result in an earlier recognition of a capital gain, so investors should try to avoid them if at all possible.
***This article is designed to give you an overview of the upcoming changes associated with the rollout of the new cost basis legislation. If you would like a review cost basis methods and alternatives please review my article link at the end of this publication.
The cost basis reporting requirements that have started to go into effect were actually established in October of 2008 through the Emergency Economic Stabilization Act. Most people remember this landmark legislation as the financial bailout of Wall Street; however, a small piece of the bill was established to reduce the amount of under reporting of gains by taxpayers. The soon to be implemented requirements will force firms to report the adjusted cost basis for certain “covered” securities directly to the IRS. The rollout of the requirements for covered securities will occur in three separate phases that include three different categories of investments.
1. Equities “ The first phase of cost basis reporting requirements was rolled out on January 1, 2011. The new requirements will be applied to most stocks, including foreign stocks acquired on or after January 1, 2011. The default method of reporting cost basis for stocks will be the first in first out method or FIFO. There is one notable exception to the stock reporting requirements, which excludes stocks purchased through a dividend reinvestment program or DRP.
2. Mutual Funds, other RICs, and DRPs “ The second phase of cost basis reporting requirements will be applied to DRP stocks, mutual funds, and other Registered Investment Companies (RICs) like most ETFs or REITs that are acquired on or after January 1, 2012. While the default method for these securities is FIFO, brokerage firms have the option to elect the average cost basis method as their default method. While most firms appear to be using the average cost basis method as the default for mutual funds, that doesnt seem to be the case for the other securities that are listed in this category of the rollout.
3. Debt Instruments, Options, and Other Securities “ The third and final phase of the new requirements involves debt instruments like bonds, options, and other specified securities. All basis reporting requirements will be applied to securities purchased on or after January 1, 2013. In addition, the default method for reporting basis in this category is also FIFO.
Other aspects of the law that investors should be aware of include:
Uncovered Securities – It is important to note that the responsibility for reporting the cost basis of securities purchased prior to the rollout dates listed above will remain the responsibility of the taxpayer. As a result, the brokerage firms are not required to report information to the IRS regarding the sale of “uncovered” securities.
Simple Wash Sale Accounting – A wash sale is basically the disallowance of a loss when an investor sells a security and repurchases the same or a substantially similar security within 30 days across all the taxpayers accounts. The new law will only require firms to automatically account for wash sales when they involve the repurchase of the exact same security inside the exact same account.
Cost Basis of Gifted Stock – One unexpected benefit of this legislation is the requirement that firms must maintain the complete cost basis for covered securities that are received as gifts. The reason that this new feature will be a welcome change has to do with the complicated nature of tracking gifted stock cost basis.
For example: Grandma gives you 1 share of XYZ stock that is worth $2 on the day of the gift. She originally purchased XYZ for $5 dollars ten years ago. The rules regarding gifted stock state that you can only sell XYZ for a loss if the stock falls below the lower of the donors purchase price or the market value on the day of the transfer, which would be $2. On the flipside, you can only realize a gain once the sale price is higher than the higher of the donors purchase price or the market value on the day of the transfer, which is $5. All sales of XYZ between $2 and $5 result in no gain or loss.
Because most recipients of gifted stock tend to incorrectly track their cost basis, this new law removes that burden from the recipient and places it with the brokerage firm.
Basis Transfers Between Brokers “ One of the most annoying things that clients have to deal with when they change firms is that the cost basis of their securities stayed at their previous firm. The new legislation specifies that a firm must provide a transfer statement when transferring assets to another firm. Transfer statements for covered securities must include the transfer date, security identifier, acquisition date, covered and uncovered status, cost basis, and holding period. Keeping track of cost basis between institutions is about to get a whole lot easier.
New Deadline for 1099-B Reporting “ For those of you that like to get your taxes done as soon as possible, you are not going to enjoy that the IRS will be permanently moving the filing deadline for 1099-Bs from January 31st back to February 15th starting in the 2011 tax year.
Overall the new reporting requirements will produce a net long term benefit to investors as it will remove most of the tedious bookkeeping from their plate. It should also give people a sense of comfort that going forward they wont have to research their cost basis every time they change firms. While the impact of the legislation should be mostly positive, getting stuck with default cost basis methods isnt a plan most people want to adopt. If you or your advisors arent already aware of the most flexible option for reporting cost basis, specific lot identification method, then you might want to do some research.
Internal Revenue Bulletin: 2010-47: Basis Reporting by Securities Brokers and Basis Determination for Stock
Dont lose your shirt on Mutual Fund Sales: This article elaborates on the differences between the default methods discussed above and the specific lot identification method that more proactive advisors recommend.