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Cost Basis Reporting Rules

In this audio stream, Michael Kitces covers the new cost basis reporting rules enacted under the Emergency Economic Stabilization Act of 2008.

Note that the new tracking rules will require any financial intermediaries (i.e., generally all brokers and custodians, as well as certain other types of financial institutions) that currently issue Form 1099-B to report using an updated version, which tracks not only the gross proceeds from sales of securities, but the cost basis, acquisition date, amount of gain/loss, and character of the gain/loss (i.e., short-term or long-term). Actual reporting on cost basis will be phased in over time, with equities in 2011, mutual funds and dividend reinvestment plans in 2012, and bonds and other securities in 2013.

Michael Kitces on Cost Basis Reporting Rules

If you prefer, you can read the entire transcript after the jump or download this and other audio webcasts from the Personal Financial Planning Section on AICPA.org.

Michael Kitces, Director of Research, Pinnacle Advisory Group. Michael is the publisher of the e-newsletter The Kitces Report and the blog Nerd’s Eye View through his website kitces.com, dedicated to advancing knowledge in financial planning.


This audio webcast was originally recorded Jan. 3, 2012.

On behalf of the AICPA's Personal Financial Planning Division, this is Michael Kitces, here to discuss the new cost basis reporting rules coming into effect in 2011, 2012, 2013 and beyond.

For those who aren't aware, the Emergency Economic Stabilization Act of 2008, the so-called bailout bill that authorized TARP, actually included a number of tax-related provisions buried in it as well, including a new one requiring financial intermediaries -- brokers, custodians and those who hold investment accounts for clients -- to begin to track cost basis on securities and investments and actually report on them, both to the taxpayer and to the IRS.

Beginning with this upcoming 2011 tax season, the IRS has actually modified Form 1099-B, where interest, dividends and the proceeds from security sales are reported to include new sections that will report not only the gross proceeds from a sale, but the cost basis, the acquisition date, and therefore the amount of gain or loss and the character of that gain or loss, whether it's short-term or long-term.  Copies of the new Form 1099-B, reporting gains and losses, are going to be sent both to taxpayers and to the IRS for subsequent reconciliation down the road.

Now, the new rules stipulate a pretty wide range of investments that will be covered by the new rules -- in essence, any form of stocks, any form of mutual funds, ETFs, bonds, commodities, options, derivatives, and in essence anything else that the IRS and Treasury decide that they want to cover will be covered under the new rules.  But they do phase in over several years, and even though the legislation was originally passed in 2008, the new rules actually state that cost basis tracking only begins incrementally for different securities over time.

The starting point is for equities -- common stocks that are traded on the stock exchanges for which cost basis tracking began in this current 2011 year that we're now wrapping up, and you will see the new Form 1099-B reporting on these when they're sent out in February.

Beyond equities for 2011, the rules then phase in to include mutual funds and dividend reinvestment plans of 2012, and then essentially all other financial instruments, bonds, options, commodities, derivatives, et cetera in 2013.  And so custodians and brokers have been phasing in their systems over the past year and heading into the coming year to try to deal with the new rules as they come into place.

The long-term opportunity for this is ultimately a simplification in cost basis reporting.  The new rules present the opportunity that at some point down the road, when everything has been fully phased in and securities have been tracked for a period of time, that there will be no more heavy-duty lifting on reconciling cost basis for clients on trying to do the forensic accounting necessary to dig through a client's transaction history just to figure out what the cost basis is.  Instead, cost basis will simply be reported on the Form 1099-B, and we can rely on that both for anything from determining the potential unrealized gains and losses in the portfolio for transaction purposes to reporting on the realized gains and losses that actually occurred in the portfolio for tax reporting purposes at the end of the year.

Unfortunately, though, in the interim over what may be a number of years, the situation gets a little bit messier.  The effective dates that I've mentioned, 2011 for equities, 2012 for funds and dividend reinvestment plans and 2013 for all other financial instruments, are the effective dates for what makes securities so-called covered securities.  And a covered security simply means a security that will be subject to cost basis tracking and reporting.

And so for most clients, they will have in essence a split of covered securities -- things that were bought after the effective dates -- and non-covered securities -- things that were bought before the effective dates -- for which the taxpayer is still responsible for their own reporting.

And so for a number of years here, until clients have eventually turned over most or all of their investment positions in their portfolios, we will still have to deal with the fact that some positions will be reported on while others will not be reported on, and some work will be left up to financial planners and accountants to sort all of that out until we get to the long-run situation where everything is simply tracked and life gets a whole lot simpler.

One of the major issues that we'll have to deal with going forward, though, is because cost basis is going to be tracked by custodians and brokers automatically, the selection of a proper method of accounting for how those sales are sold, particularly any time we have a partial sale, becomes far more important than ever.  Now, most custodians will still honor what in essence are the fixed traditional methods of accounting for investments -- FIFO, first in, first out, LIFO, last in, first out, or highest-cost method, lowest-cost method, average cost from mutual funds, and simply specific bought identification, where we identify which lots we want to use at a particular time.

By default, custodians will assume that taxpayers are using average cost for mutual funds and FIFO, first in, first out, for everything else.  Although in reality, when we look at it from a planning perspective, those probably will not really be the most appealing options for most taxpayers.  Instead, most people will probably want to choose some form of highest cost, which in essence takes the biggest losses first, then the smallest losses, then the smallest gains, and then the biggest gains.  So this, in essence, is a methodology to minimize ongoing capital gains exposure.

Unfortunately, though, if clients actually want to be subject to a highest-cost methodology, they do need to proactively contact the custodian to actually inform the custodian that they wish to use highest cost.  Failure to inform the custodian simply means the custodian reverts, again, back to the default rules of FIFO for any securities except mutual funds and an average cost for mutual funds.

FIFO in particular will have a tendency to produce not the smallest gains and biggest losses, but to produce the biggest gains and the smallest losses, as investments generally go up, at least on average over time, and the oldest shares tend to be the ones with the biggest gains.

Now, the caveat to the highest-cost methodology that you should be aware of is highest cost itself has a challenge, while it does pick quite literally the highest cost shares, and therefore the ones with the small -- the biggest losses or the smallest gains, it generally ignores holding period.  And so taxpayers run the risk of taking a smaller short-term gain instead of taking a slightly larger long-term gain that actually could have been worth more on an after-tax basis.

Some custodians actually responded to this by creating a new methodology.  Although it varies by the particular custodian and has different names, usually something like beneficial tax lot, optimal tax lot.  Some of them simply call it tax-sensitive highest cost.  And it is a methodology that in essence chooses short-term capital losses and long-term capital losses, and long-term capital gains and then short-term capital gains last.  And so it is a form of highest cost, but one that is also sensitive to short versus long term and what is more favorable.

Now, notwithstanding the fact that many clients will prefer a highest-cost methodology because it minimizes gains, some clients actually should be aware that the best option may be a lowest-cost methodology that deliberately recognizes gains.  Why would clients choose to recognize gains?  Two primary reasons.  The first is, in 2012 in particular, we have the opportunity for zero percent capital gains for low-income clients, those in the bottom two tax brackets.  And so for clients that are at a lower income level, choosing a highest-cost method that picks losses first actually can be harmful.  It will harvest a loss that's eligible for zero percent rates anyways, generating no tax value, while buying the new security at a lower cost essentially exposing them to higher capital gains in the future when rates are scheduled to rise.  The superior method would be a lowest-cost method that deliberately recognizes gains at zero percent tax rates and then steps up the basis to a new higher level when the new security is purchased.

Other clients may prefer a lowest-cost methodology even if they're at higher income levels and face 15% capital gains rates simply because rates are scheduled to rise so dramatically in just 12 months from now, beginning in 2013.  Not only is the 15% rate is scheduled to rise to 20%, but on top of that, clients who are at higher income levels will also be subject to the 3.8% Medicare surtax on unearned income, taking high-income taxpayers from a capital gains rate of 15% to 23.8% in the span of just a year.  Needless to say, we're facing a tax rate rise that at the margin would be more than a 50% increase in tax rates.  It could be highly favorable to people to harvest their capital losses sooner rather than later.

In terms of average costs for mutual funds, we similarly see clients that are choosing to opt out of average cost for mutual funds.  Traditionally, the primary reason for using average cost was not a -- was particularly advantageous to high-income taxpayers nor low-income taxpayers, it was simply advantageous because it was simple, it was easy, it was an easier way to track cost basis than trying to identify individual loss.  Well, in a world where cost basis is going to be tracked automatically by the custodian anyways, arguably there's little reason to use average cost, as we could specifically choose either highest cost or lowest cost, whatever works for a client, depending whether they want to maximize gains or minimize gains.  But in no event is it particularly helpful to simply use average cost.  That leaves them subject to some random amount of gains based on what the average gain turns out to be over all the shares that have been purchased.

Unfortunately, though, for clients who want to use something besides average cost, again, they need to (A) proactively opt out of the average cost methodology so that it's not used as a default, and (B) must do so before the sales actually occur.  In the terms of average cost, once a sale actually occurs, all of those shares are permanently locked into average costs, and the methodology can only be changed for new shares going forward.

On the plus side, though, the IRS has actually relaxed the constraints on changing methods of accounting for cost basis, and beginning in 2012, clients can change their cost basis method of accounting any time they want.  They can change from highest cost to lowest cost.  They can change from average cost to something else any time they want without any notification requirements to the IRS.  They simply make a notification request to the custodian who will be tracking the new method of accounting and use that new method for all points going forward from there.  Again, the only caveat to that, shares of mutual funds that have been average cost in the past that have already had sales are locked into average cost and cannot change.

So suddenly there is a new burden, in essence, on planners and accountants in the coming year to make sure that cost basis methods of accounting are selected proactively in advance, because once the sales occur, they can no longer be changed, and the rules are quite clear now that once a sale has actually occurred and the transaction has settled, whatever lots were identified as sold are locked in place and cannot be changed after the fact.  The custodian will report whatever lots were sold based on the method of accounting that was in force at the time.  Then if a client realizes at the last moment they wish something to change, it needs to be done by the time the transaction settles.

Some other ways that the methodologies will be simplified going forward, the IRS has also stipulated that wash sales now must be tracked directly by the custodian as a part of the methods of accounting.  Now, the caveat to this is wash sales will only be tracked if it is the absolute identical security -- in essence, the same CUSIP or security tracking number, and is done in the same account.  This will not cover all wash sales, obviously, as a wash sale includes any substantially identical security that's repurchased in any accounts in the forbidden time period.  But basic wash sales that occur within the same account with the same security will be tracked automatically, and cost basis will be addressed at making, again, the reporting obligations a little bit easier for taxpayers in the long run.

The challenge for many firms in the immediate term, though, especially if they are actually helping client with investments, and especially if they're managing the investments on clients' behalves, is there is now a possibility that the firm's portfolio management software may not match the custodian's portfolio management software.  And given the guidance where the custodian will be reporting results on the Form 1099-B to the IRS, this in essence means the custodian's results trump all.  And so while in the past, if a firm's records didn't match the custodian, the firm might simply advise the client, "Well, we are certain we have accurate cost basis reporting.  You could use our numbers going forward," and the firm would simply notify the custodian of the update.

Now, in essence, the reverse occurs.  It is actually the custodian's numbers who are deemed to be, quote, right, at least with respect to covered securities, and the firm has to keep their numbers in compliance and in conformity with the custodian.  The firm may still obviously track non-covered securities on their own and simply advise their clients.  And so many firms that do investment management in essence find an additional burden on themselves to make sure that their systems match their custodian's and that they are reconciling that software on an ongoing basis.

So bringing it all together, what we see is in the long run a greatly simplified cost basis reporting structure where gains and losses as well as their character are reported on a Form 1099-B.  Accounts can simply take that, insert the information directly onto the Schedule D, and have an accurate reporting Schedule D with really only an obligation to adjust for any wash sales that occurred across accounts instead of within the same account.

But in the intermediate term, we definitely see additional complexities that clients will have to deal with, ranging from non-covered securities, where cost basis still has to be tracked and reconstructed, and perhaps more importantly a proactive decision about a method of accounting and what will be used, because frankly in most cases clients will not want to use the defaults of either average cost for mutual funds or FIFO for everything else.  They will almost certainly prefer to use either highest cost or lowest cost, depending on their situation.  That can be changed over time as their situation changes.  But once sales occur, any sales that are locked in in FIFO, obviously, the lots are literally sold and reported, and they can't be changed.  And once any shares are sold on an average cost basis for mutual funds, all shares that are still held are locked into that average cost methodology.

So if firms want to take advantage of whether it's highest cost or lowest cost for a particular client, they need to proactively select a method of accounting and notify the custodian what that method will be before sales occur heading into 2012.  Technically, any transactions that have occurred for 2011 are already locked in with respect to equities that were purchased in 2011.  But for the majority of consumers that hold mutual funds, and in particular may want to wish to avoid the average cost accounting for mutual funds, the time is really now to make those methods of accounting to avoid having clients locked in going forward.

With that, I hope some helpful perspective on the new cost basis rules that are coming up and what you may need to deal with in the coming weeks and months.  To keep up with the latest news and resources to help you navigate issues such as these in your practice, be sure to read the AICPA PFP News, which is delivered to the PFP section members weekly via e-mail.  For regular updates on legislative and regulatory news, visit AICPA.org/PFP/advocacy.  This is Michael Kitces.  Thank you for joining us today.


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