If you think you do not need to track cost basis on your own because brokers must now report to both you and the IRS the cost basis for any stock sold, be aware of some potential pitfalls.
First, new cost basis reporting requirements are being phased in. New regulations requiring brokers to report cost basis generally apply only to stocks bought after January 1, 2011. Mutual funds will become subject to the same provisions in 2012; bonds and options will follow in 2013. However, for stock bought as part of a dividend reinvestment plan, or DRP, the new provisions will apply only to purchases made on or after January 1, 2012. As a result, for most DRP stock purchased before that date, in most cases you or your tax preparer will still be responsible for calculating accurate cost basis information.*
Because DRPs typically involve many purchases over a long time, calculating the cost basis for a DRP stock could be challenging. Fortunately, there is also a provision that makes the calculation easier. For stocks held in DRPs, the cost basis of all purchases in the plan can be averaged to determine the cost basis for individual shares sold.
The ability to average sales from a DRP applies only to plans whose documents specify that at least 10% of every dividend paid must be reinvested in identical stock. To be considered identical, the stock must have the same CUSIP number, which would not apply to purchases of the same stock made outside the DRP.
Even after adjusted cost basis reporting is available for DRP stocks, you can still specify which shares are considered the ones sold for tax purposes. However, you must do so before the trade settles – typically, three days after the transaction.
You can include any transaction costs paid as part of your adjusted cost basis. Even though your adjusted cost basis may be calculated by someone else, it may still be a good idea to keep documentation of any purchases or sales to make sure it matches the information being supplied to the IRS.
*Note: The reporting regulations already apply for DRPs that do not require reinvestment of at least 10% of every dividend paid.
Are there exceptions to new cost basis reporting rules?
New provisions that went into effect in 2011 requiring brokers to track and report adjusted cost basis for stocks have special provisions that apply in certain situations.
Wash sales: A wash sale occurs when a substantially identical security is purchased within 30 days before or after the security it replaces is sold; when that happens, any losses resulting from the sale are not immediately deductible for tax purposes. The new regulations still require taxpayers to comply with the IRS regulations governing wash sales. However, brokers are required to adjust the cost basis of a wash sale only if the newly acquired securities are identical to the securities sold, meaning the securities involved share the same CUSIP identification number.
Brokers also are not required to report adjusted cost basis for wash sales when the purchase and sale transactions occur in different accounts. However, taxpayers are still responsible for accurately reporting the proceeds of any wash sale transactions, regardless of whether the purchase and sale are made in the same account.
Short sales: In the past, the IRS required brokers to report a short sale for the year in which the short position was opened; however, the proceeds of a short sale generally were taxed in the year in which it was closed. The new regulations correct that discrepancy. In addition to requiring brokers to track cost basis, the new regulations mandate that the cost basis of a short sale will now be reported in the year in which the short is closed. For example, if you initiated a short position in July 2011 that was closed two months later, the cost basis should appear on the 1099-B form for 2011 that brokers must submit to the IRS in early 2012. However, if the position had not been closed before January 1, 2012, the cost basis will be reported to the IRS only after the position is closed. If you close the position after January 1, 2012, it would appear on the 1099-B due in early 2013.
Even though brokers must now supply additional information about the net proceeds of a stock sale, it is worth remembering that the individual taxpayer is still responsible for accurately reporting information to the IRS.
The Certified Financial Planners at New Wealth Advisors will gladly answer any cost basis questions you may have related to your investments.