Extensive new requirements were placed on broker/dealers that report gross sales proceeds on Form 1099-B for sales of securities. The Energy Improvement and Extension Act of 2008 introduced the new concept of "covered" and "non-covered" securities. Treasury Regulations published 10/1/2010 provided further specific guidance.
Starting with the 2011 tax year, you also will be required to fill out a new Form 8949 to report the cost basis of the securities you sold.
If you sell an investment that is "covered" under the effective dates of the legislation, the broker must report the adjusted cost basis on your Form 1099-B and whether the capital gain/loss is long-term or short-term. In the past, only the gross sales proceeds were reported and not the cost basis.
What's the definition of a good tax accountant?
Someone who has a loophole named after him!
The term "covered" means any security acquired after the effective date for that type of investment or any security that was received into the account with a cost basis statement from the transferring brokerage firm. A "non-covered" security is one that does not fall under the new rules.
The dates that securities become "covered" vary based on the type of investment:
January 1, 2011: Stock in corporations (including REITs and ADRs) and some ETFs January 1, 2012: Mutual funds, stock dividend reinvestment plans, and remaining ETFs January 1, 2013: Notes, bonds, options, commodities, other types
All securities acquired before the effective date for that category are considered "non-covered" securities and are kept in a separate pool for cost basis record-keeping for that particular investment. If the mutual fund or broker has accurate cost basis records for all of the shares, they can make a "single-account" election and keep both covered and non-covered securities in one pool.
1. The double category average cost method cannot be used after April 1, 2011.
2. Tax information statements on corporate reorganization actions must be posted on the public website of the corporation for ten years (good!)
3. If you do not want to use the default method of cost basis matching selected by the brokerage firm (usually first-in-first-out or FIFO), you can select from a choice of alternate methods made available by your brokerage firm or mutual fund company. Your selection must be made in writing or electronically (but not verbally.)
4. The brokerage firm is responsible for applying corporate reorganization actions to cost basis data only if the action occurs during the period that the security is in their custody.
5. Form 1099-B reports will now be issued to Subchapter S corporations.
6. When applying the FIFO default method, tax lots with unknown acquisition dates are now specifically required to be used first. In the past, some taxpayers skipped over tax lots with unknown purchase dates in applying the FIFO rule, but now the broker/dealer is specifically required to use those tax lots first for cost basis reporting under the new law. Why is that bad? It limits your options because the taxpayer is expected to report cost basis consistent with the broker report. If you don't know the acquisition date, you probably don't know the cost basis of that tax lot either. Ideally, you would choose to sell specific identification tax lots whose purchase dates and costs you know, postponing sale of the unknown acquisition date tax lot until it goes into your estate and gets stepped up to market value. There are millions (billions?) of shares of stock in this country that are not being sold because the owner does not know the cost. If the broker uses the FIFO default method and you sell any shares without remembering to specifically identify a tax lot, the unknown acquisition date tax lot will be reported on your Form 1099-B (without a cost basis) and it must be reported on your tax return. By the time you realize what happened, you cannot go back and use the specific identification method after the trade has been confirmed. You are then forced to scramble to find a cost basis for ancient tax lots. Therefore, you will probably report zero cost basis for the unknown acquisition date tax lot, incurring more capital gains tax than you otherwise would have owed.
Are you breathing a sigh of relief that you can count on your brokerage firm to keep all your cost basis records for you? Don't count on it. This legislation was designed for the benefit of the IRS to collect more taxes, not for your benefit. You still must be vigilant in accounting for your own cost basis because:
1. It will take many years before your portfolio has 100% turnover for all holdings to be "covered securities" under the new rules. The brokerage firm is not responsible for your beginning cost basis on the securities you own now.
2. Wash sales in different accounts are not the responsibility of the brokerage firm to track. This happens more commonly than you would think. For instance, a husband and wife both own shares of the same mutual fund in their separate names. A withdrawal is made from one of the accounts to pay a bill, and the quarterly dividend reinvestment occurs in both accounts less than 30 days later. This can easily invoke the wash sale rule if the sale was at a loss.
3. Certain transactions are difficult for brokerage firms to handle and the chance for error is high, such as cash to boot mergers, stock rights, and mergers involving the exchange of multiple securities.
4. The brokerage firm will take the easy way and not allocate any of your cost basis to the receipt of stock rights if they don't have to (when the allocation is less than 15% of the cost.) This leads to higher capital gains taxes for you. If you elect to allocate basis, you not only have to keep your own cost records, you have to make sure the brokerage firm adjusts their records, too.
5. Once the cost basis is reported by the broker on Form 1099, it is presumptive proof of the cost basis, even if it is wrong. If you report an amount different from the broker's reported cost basis, it will be a red flag that increases your chance of IRS audit. Then you have to jump through hoops to demonstrate to the IRS that the reported amount was incorrect. Even if you report the correct amount on your tax return, you have to get the brokerage firm to correct the cost basis for the remaining tax lots for an investment you own with multiple acquisition dates.
6. The brokerage firm will not have the correct data to compute the cost basis of future spinoffs, split-ups, split-offs, and stock rights if you do not have an accurate starting cost basis for the original stock. Accountants call this the GIGO method: "garbage in garbage out."
7. Your brokerage firm may not know the basis of assets inherited by or gifted to you. The executor may have elected to use the alternate valuation date for the assets in the estate that you inherit. The basis of your gift may not be determinable until the date of sale due to the cost basis rules specific to gifts. Fair market value information on the date of the gift or date of death will be reported by the broker, but that may not necessarily be the correct cost basis.
Basically, this legislation has created a massive cost basis reconciliation project for every taxpayer/investor because now they must make sure that not only are their own records correct, they must make sure that what the brokerage firm has on file for them is accurate, too. The onus is then on the taxpayer to get the brokerage firm to correct any errors to avoid IRS reporting problems later.