The Investment Scientist

New IRS Rule on Cost Basis Reporting

Posted on: February 10, 2012

Tax Form

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.

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1 Response to "New IRS Rule on Cost Basis Reporting"

Would this also apply to securities inherited in 2011? That is are they going to provide the step up in basis?

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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