Calculating Cost Basis: A Taxing Exercise

By Jonnelle Marte

New cost basis rules will make tax filing season a little easier for investors next year (when filing 2011 taxes) by shifting some reporting responsibilities to financial firms and away from investors.

But, investors aren’t off the hook. To avoid a huge tax headache at the end of this year, investors will need to be proactive by coordinating with their brokers, deciding earlier how they want to report trades and keeping more precise records.

Starting this year, financial institutions and brokers are required to track their customers’ cost basis — or the price they paid when they purchased shares, including commissions — and report that information to the Internal Revenue Service.   Investment companies had to start tracking and reporting stocks and some exchange-trade funds this year but reporting requirements for other investments, such as mutual funds, bonds and options are being phased in during 2012 and 2013.

With many institutions setting default methods for how they want to report cost basis, the onus is on investors to check in early if they want to use a particular method when reporting trades—such as whether the oldest shares should be sold first, if an average cost for all the shares should be used or if specific shares should be sold. The default method for reporting stock trades, for instance, is “first in first out,” where the oldest shares are reported as being sold first. That might be bad if your shares have grown substantially in price since you first purchased them. In that situation you might want to minimize your capital gains—and your tax bill—by selling newer shares, which you purchased at a higher price.

If you don’t tell the company which method to use before the trade settles–which typically happens three days after the trade takes place–the provider will use its default, advisers say. But if you make your wishes known the deadline the company has to use the method you selected, an IRS spokesman said.

“The risk is that if you don’t act to figure out what method is best for you then at the end of the year that’s not going to be calculated necessarily in your interest,” says Constance Stone, president of Stepping Stone Financial, a registered investment advisory firm based in Chagrin Falls, Ohio.

Before now, investors were solely responsible for calculating their cost basis for investment transactions – a task that even the pros say isn’t easy. And since the IRS required little documentation to prove what method was used, mistakes could go uncaught—and so could fraud—when investors reported gains and losses.  Taxpayers could also decide the sale methods for all of their trades altogether at the end of the year, when they had a better idea of what their overall tax bill could look like.

Now investors will have to make these decisions at the time of trade, forcing them to spread out their tax planning throughout the year, says Joseph Votava, president of Seneca Financial Advisors, based in Rochester, N.Y.

The new rules will be felt more acutely next year, when investors receive 1099-B forms from investment companies that show the cost basis information for shares purchased in 2011. The forms should reflect your proceeds from brokerage transactions along with the cost basis information for shares purchased or acquired this year and it should be reported in the method you selected.  Even with this documentation, investors will still be responsible for calculating cost basis on many of their trades, since financial firms and brokers are not required to provide the cost basis for shares purchased before this year.

“You as an investor have to agree with the number sent to the IRS [by the financial institution], so you’re still going to have to keep your records and maintain them,” says Stevie Conlon, senior director and tax counsel at Wolters Kluwer Financial Services. “This will probably force (people) to become more educated (to follow) these rules.”

Confused yet? Readers, how will you handle your cost basis calculations? Why?