If you own mutual funds through a brokerage account, you have gotten a letter or will get one soon asking you to make a cost basis method choice before year end. What's this all about?
The Emergency Economic Stabilization Act of 2008 requires that when brokers report the sale of securities to the IRS, they also include the customer's adjusted basis in the sold securities and classify any gain or loss as long-term or short-term. The Act was effective for individual securities acquired on or after January 1, 2011. For mutual funds or stock in a dividend reinvestment plan (DRIP), the new reporting requirement is effective for covered securities, that is, securities acquired on or after January 1, 2012.
Prior to this change in the law, you have received a 1099-B from your broker showing the proceeds of your sales for the year but not showing how much you gained or lost on each sale. The IRS, starting in 2012, is demanding gain or loss information for covered securities, thus, the new 1099-B form. Brokers have until February 15, 2012 to get the new 1099-Bs to you.
There are two problems: (1) if your securities aren't covered by the new rules, you still have to figure out the basis yourself; and (2) if your securities are covered, your broker may select a default method of basis determination. If you want to use a different method, you must tell your broker before you sell covered shares. That is why you are being asked to choose a method now, or let your provider's default method control.
There are several methods of determining the basis of assets sold. Average basis will likely be your fund's default method. Using the average method, the cost basis of all the shares of an issue of stock, say AT&T, are added up, the total is divided by the number of shares and an average basis per share is obtained. This is multiplied by the number of shares being sold. This is the simplest and least burdensome method.
Beginning in 2012, treasury regulations treat mutual fund and DRIP stock that is a noncovered security (acquired before January 1, 2012) as being held in a separate account from stock that is a covered security (acquired on or after January 1, 2012). Because stock is averaged on an account-by-account basis starting in 2012, the basis of shares that are covered securities will be the average basis of only the covered securities and the basis of the shares that are noncovered securities will be the average basis of only the noncovered securities. However, if a broker has accurate basis information for shares that are noncovered securities and makes a "single-account election" for some or all of the shares, the shares subject to the single-account election are treated as covered securities and their basis is averaged with the shares that are covered securities.
A second method is called first-in-first-out, or FIFO for short. Under FIFO, the stock or fund shares that are acquired first are deemed to be sold first. This lets you realize long term gain (if any) first before getting to the less tax-favorable short term gains. On the other hand, FIFO does not give you an opportunity to choose to increase or decrease gain or loss by selection of specific lots or shares. If you have stocks whose acquisition dates are unknown, regulations require that they be sold first if a FIFO election is in force.
A third method is by specific lot identification (SLID). You notify the broker in writing which blocks of stock you wish to sell. Each block has its own cost basis. For sales where you cannot specify your lots, such as check-writing or systematic withdrawals, a secondary cost basis method is available. If you do not select a secondary method, FIFO is used.
Imagine the complexity of tracking basis for individual shares in a DRIP. Each dividend buys fractional shares, you might add a tenth of a share here, a half a share next quarter, etc. It would be very burdensome to keep track of all those individual fractional shares obtained each quarter through re-investment of dividends.
Depending on the broker, other methods of block identification may be available by standing order.
Last-in-first-out (LIFO) sells the stocks acquired last and works back to the stocks acquired first. This tends to sell the lowest gain stocks first but may result in some short term sales.
High-cost-first-out (HIFO) sells the stocks with the highest cost first, which truly minimizes gain but again may result in some short term sales.
Low-cost-first-out (LOFO) sells the stocks with the lowest cost first, which maximizes gain and doesn't seem to make sense from a tax planning viewpoint but may make sense if you are looking to take some gains in a year when you have some losses to offset.
Loss/gain utilization (LGUT) is a method that sells stock in a way to minimize tax consequences. For sales that would result in a loss, shares considered short-term are sold first, followed by long-term shares. For sales that would result in a gain, long-term shares are sold first, followed by short-term shares since long-term capital gains rates are more favorable.
Beginning January 1, 2012, if you have not elected a basis method and the fund's default is average cost, you may retroactively change the fund's default to another method before the date of the first redemption or transfer. Whether you are changing from average cost to another basis method or changing to average cost from another basis method, that request must always be in writing. You may always change your cost basis method on future purchases, no matter what cost basis method you choose.
