Taxes (TAX)

[cintrix]

Cost Basis Reporting Rules Changing In 2011
November 10th, 2010 by Brian Castorena

Based on legislation passed back in 2008, the way that brokerage firms like Schwab, Morgan Stanley, etc. report your gain or loss on stocks will change starting in 2011. First, and perhaps most significantly, the REAL gain or loss on stocks going forward are going to be reported to the IRS, which leaves little room for interpretation or changing your mind on which lot of stock was sold, newer or older. The exception to this will still be that if your current broker does not have accurate basis/cost information for a stock you sell, you will still need to refer back to your records to determine that cost basis yourself.

Which leads to the second issue – you need to direct your brokerage house on which method you would like to use to determine which stock is sold in a transaction. For stocks there are two methods: First In, First Out (FIFO) and Specific Identification. In FIFO, your oldest lot of stock is sold first until you finally get to more current holdings. In Specific Identification, you choose which lot of stock to sell in each transaction. Most people are currently on a FIFO system but this rarely provides the best outcome tax wise. The Specific Identification method is often better since it allows you to use old stock or newer stock to mold the gain or loss according to what may be needed for the tax year. It requires a little more forethought on your part when you sell, but gives you control of the year end outcome. Here’s an example:

You bought 3 lots of Apple: 100 sh for $1000, 100sh for $2000 and 100sh for $3000. You then want to sell 100sh for $4000. Under FIFO, you would have to use the first lot that you bought for $1000, which results in a $3000 gain that you would pay tax on. Under specific ID, you could choose any lot or combination of lots to determine the outcome. You want to minimize taxes so you use the $3000 lot and only have a $1000 gain. You have a loss from your business so you go with the first lot of $1000 since the $3000 gain would be offset by your loss and you don’t pay any tax. That’s an easy example of how this can help or hurt.

You can choose the same method or another method for Mutual Funds. Mutual Funds have four options: FIFO, Specific ID, Average cost single category and Average cost double category. The double category method is rarely used because of its complexity, but may be best in certain situations. Most people will find that Specific ID or Average cost single category are the most beneficial, with FIFO trailing behind again. Specific ID works the same for stocks and mutual funds. For the Average cost method, you total the cost basis of each entire fund and divide it by the number of shares you own in that fund to determine your average cost per share. You would use this average per-share cost for all future sales as long as you hold the position, adjusted for any subsequent purchases. Once you start using the average cost method for a particular fund, you can’t switch to another method without permission from the IRS. Although the average cost method gives you far less flexibility than specific ID, it generally gives a better result over time than the default FIFO method.

So it’s time to take a more proactive approach to your investing and become better informed, especially when it comes to selling stocks or mutual funds. This can make tax planning all the more necessary throughout the year and certainly at year end. Be sure to check with your tax professional and financial adviser before entering into any transaction that may have significant tax consequences. Remember, a little forethought may save lots of tax dollars.
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