September 13, 2012|
New "cost-basis" reporting rules for investments went into effect in 2011...sort of. These new rules are being phased in over a three-year period. What's more, due to the way the changes are being implemented, the "old rules" and the "new rules" will continue to exist side by side for the foreseeable future. Old rules: If an investor sells securities, he or she is generally required to report the difference between the sales price and the cost basis as a taxable gain or loss on the tax return for the year of the sale. The financial institution provides most of the relevant information on Form 1099-B, but it is the investor's responsibility to figure out the cost basis. This can be difficult if the investor holds multiple shares of the same security purchased at different times. In addition, the investor could use one of several methods to determine which shares were sold. For instance, the investor might choose to identify the securities with the highest cost basis to effectively decrease the taxable gain for tax purposes or indicate a sale of the securities with the lowest tax basis to increase the tax gain, if warranted. The decision of the accounting method was made at tax return time. New rules: A law enacted back in 2008 shifts the cost-basis reporting responsibilities to the financial institution. It must indicate the cost basis for "covered securities" on the Forms 1099 it issues to investors. But the new rules only apply to securities acquired on or after the following dates: • January 1, 2011, for stocks, American Depository Receipts (ADRs), real estate investment trusts (REITs) and exchange-traded funds (ETFs) taxed as corporations. • January 1, 2012, for mutual funds, dividend reinvestment plans (DRPs) and other ETFs. • January 1, 2013, for all other remaining securities, including options, fixed income instruments and debt instruments. Therefore, the new rules apply to stocks an investor acquired after 2010 and sold in 2011. But they do not apply to stocks an investor acquired before 2011, regardless of when they are sold. The financial institution will use a default method to determine the cost basis of the securities unless otherwise instructed by the investor. For instance, the default method for stocks is the "first in, first out" (FIFO) method. The FIFO method assumes that the first shares acquired were the first one sold. Conversely, financial institutions will generally use an "average cost" method as the default for mutual funds. This is the total cost of shares divided by the number of shares. Significantly, investors can no longer choose the accounting method to determine the cost basis of covered securities at tax return time. The election must be made at the time of the transaction, or the default method will apply. Bottom line: These changes can both simplify and complicate matters for investors. It will require a careful analysis to produce the optimal tax results for each situation. Be sure to obtain professional assistance when it is warranted.