New Year, New Tax Reporting

12/07/2011 8:15 am EST

Focus: TAXES

Janet Brown

Editor, NoLoad Fund*X

If you’ve received unfamiliar paperwork from your mutual funds or brokers recently, you’re not alone, writes Janet Brown of NoLoad FundX.

New IRS rules require your custodian to know how you’d like the cost basis of your funds to be calculated, because, starting in 2012, they’re required to report your cost basis to the IRS.

Previously, custodians only had to report the gross proceeds of the sale of securities; it’s been up to the account holder to determine how to calculate gain or loss when they filed their tax return.

This new requirement only affects shares purchased on or after January 1, 2012 in a taxable account. Retirement accounts are exempt.

Cost basis is the amount an investor paid for an investment, plus reinvested dividends and capital-gains distributions. This amount is the basis for determining how much the investor gained or lost from an investment. The difference between the cost basis and the sale price of the investment equals the investor’s taxable gain or loss.

If an investment is sold for more than the cost basis, then there is a realized capital gain. If an investment is sold for less than the cost basis, then there is a realized capital loss. In a taxable account, both realized gains and losses are reported to the IRS.

Cost basis sounds straightforward, but there are a few variables to consider. As an example, consider an investor who bought 100 shares of a fund each month from January to June, ending up with 600 total shares. The following January, the investor puts in an order to sell 100 shares, but which 100 shares (or “trade lot”) should the broker sell?

If the broker sells the 100 shares that were bought in January and those shares have gained in value, the investor will be able to realize long-term gains which are taxed at a lower rate than short term gains. This option is called first in, first out (FIFO), and it assumes that the first shares that were bought are the first shares that are sold.

If the broker sells the 100 shares that were bought in June, and these shares are now worth more than the cost basis, the investor will realize short-term capital gains, which are taxed at a higher rate. This option is considered last in, first out (LIFO), and it assumes that the last shares purchased are the first shares to be sold.

The default cost-basis option at major brokers like Schwab and Fidelity is average cost. This means the broker divides the total dollar amount invested in the fund by the number of shares and uses that average as the cost, then uses first in, first out to determine long term vs. short term.

Different Brokers, Different Cost Basis
Most custodians will default to the average cost basis method unless you tell them otherwise. But check with your broker to see what cost-basis methods are available.

Many companies have posted detailed explanations of their methods online, and some brokers are offering specialized cost-basis calculations. Schwab, for example, offers a “Tax Lot Optimizer” that prioritizes losses over gains and long-term gains over short-term gains.

Wells Fargo has an option called Minimum Loss, Minimum Gain, which attempts to minimize taxes by using losses to cancel out gains. Fidelity offers ten different cost options, any of which can be used as a default method of calculating gains and losses.

We also suggest you check with your accountant or tax preparer every year to see how they’ve been calculating cost basis.

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