While investors are enjoying the end of the school season and the start of summer, it is no time to a take break from understanding the new IRS cost basis regulations on securities sold that went into effect starting in January of 2011.

That’s the word from Kenny Landgraf, Kenjol Capital Management, an Austin-based investment advisement firm. Landgraf is a Lake Travis area resident.
“For those that use the services of a CPA, now is a good time to sit down with your CPA to discuss this important tax topic,” Landgraf said. “Conversely, now is not a good time to take a vacation in understanding these new tax rules for investors and subject yourself to penalties and interest.”
All financial institutions, broker-dealers, mutual fund companies, many custodians of financial assets, banks, transfer agents and financial custodians are required to expand their reporting to the IRS to include adjusted cost basis for the disposition of certain securities in individual client accounts. For a specified set of securities purchased and sold on or after the first of the year, financial institutions will be required to report adjusted cost basis information to the IRS on Form 1099-B. They will also include information indicating whether the holding periods for the transacted securities were short-term or long-term in nature.
“These new rules were established as part of the Emergency Economic Stabilization Act of 2008 and are scheduled to be phased in over a three year period,” Landgraf said. “The objective of the regulations is to help ensure that investors accurately report realized gains and losses on securities in their annual tax filings. Under the old rules, the IRS had no way of knowing whether the taxpayer was reporting the correct tax basis unless audited, and therefore, subject to incorrect or under-reporting of cost basis by the taxpayer.”
Landgraf said some estimates have been as high as $25 billion a year in under reporting by tax payers. For decades, cost-basis reporting has been a difficult and time consuming endeavor for both taxpayers and CPA’s. This new reporting is sorely needed – the financial crisis finally forced this issue.
With the new legislation, securities sold are now considered “covered” or “uncovered.” For covered securities, brokers and financial institutions will report cost basis to the IRS and on tax Form 1099-B. Taxpayers will use Form 1099-B data in preparing their tax return filing for 2011 and following years. For securities that are considered uncovered, the taxpayer will report cost basis to the IRS. In this case, the financial institution will only report the sale transaction and the sales proceeds to the IRS — the tax payer will provide the cost basis and whether transaction is long-term or short-term.
The IRS has established the following schedule for implementation:
3 Equities including common and preferred stocks, ADR’s, exchange-traded funds, unit investment trusts, and real estate investment trusts — covered securities are those acquired on or after Jan 1. Uncovered securities are those acquired prior to Jan 1;
3 Mutual funds, dividend reinvestment Plans and closed-end funds; and
3 Debt issues such as bonds, or debentures, options, rights, warrants, and derivatives. Options will be reported on the 1099-B in the year they are closed.
“While on the surface it sounds simple, but for investors that have purchased and sold securities that are considered covered and uncovered, it may make the tax reporting more complicated during the implementation phase of the new rules,” Landgraf said.
Landgraf said that one big benefit to taxpayers of this new legislation is that financial institutions will now be required to provide a transfer statement when transferring assets to a new broker within 15 days of transfer.
“This will make tax preparation easier and eliminate the need for forensic accounting by the tax preparer to determine cost basis for the securities sold,” he said. “Also, for those investors that like to short stocks, the short sales will be reported on the 1099-B in the year the position is closed instead of the year the sale is made — another headache eliminated for the tax preparer.”
In addition to purchases and sales, the financial institutions will have to track events such as splits, reinvested dividends and mergers which can raise or lower cost basis. The will also track cost basis for inherited or gifted securities. Landgraf said another difficult area is “wash sales” in which financial institutions will have to adjust cost basis for a loss on a prior sale that has been disallowed.
“One of the biggest changes with this new regulation is that an investor must understand and select which cost basis method to use on shares sold,” Landgraf said. “You must contact your financial institution and select either the default or alternative cost basis methods provided. And, this election must be made prior to the settlement date of the security sold — previously the tax payer could wait until the tax preparation date to determine cost basis method.”
Landgraf said examples cost basis methods such as FIFO [first-in, first-out], LIFO [last-in, last-out], HICO [highest cost sold first], LOCO [lowest cost sold first], average cost, specific shares and tax sensitive may be utilized. The fact that the cost basis method must be selected and identified by the settlement date — not when tax preparation is performed the following year — makes attention to this new regulation so important.
“It’s important to understand that while a financial institution may have previously provided cost basis information in supplemental pages of a consolidated year-end tax statement, financial institutions have not provided cost basis information to the IRS prior to 2011,” Landgraf said. “That reporting will change starting in 2011 and phase in over three years. This expanded reporting to the IRS by broker-dealers does not change or mitigate any responsibilities you have to accurately report realized gains and losses in the annual tax filing.”
Landgraf said the summer homework for investors is to gain a better understanding of the new tax rules and the implications to the 2011 taxes when prepared in 2012.
“This will save you confusion during tax preparation in 2012 and hopefully keep you from incurring penalties and interest if your reported sales do not match what your financial institution reports to the IRS.” he noted. “Now is the time to start tax planning — not in 2012. The regulations will provide better information to investors, financial advisors, and tax professionals. And the good news is that investors will have a choice in the cost-basis reporting methods. By managing the amount of profit or loss in an investment, you can minimize the taxes based on your tax situation and tax bracket.”