New Cost Basis Reporting Rules Effective January 1, 2011

Under new IRS regulations, beginning with the 2011 tax year, financial institutions must report to the IRS on clients’ Forms 1099-B (Proceeds from Broker and Barter Exchange Transactions) not only gross proceeds of sales but also the adjusted cost basis for stock sold and whether the related gain or loss is long-term or short-term. The new cost basis reporting regulations implement key provisions of the Emergency Economic Stabilization Act of 2008 that apply to institutions that issue IRS Form 1099-B.

Cost basis is the original price of an asset, such as stocks, bonds, property, or equipment. Cost basis includes the purchase price and any associated purchase costs. Adjusted cost basis includes additions for sales tax, brokers commissions, improvements, selling costs, and subtractions for depreciation, depletion, casualty or theft loss.

Adjusted cost basis is needed to calculate the amount of gain or loss when an asset is sold. The gain or loss for income tax purposes is the difference between the adjusted basis of the shares and the selling price.

Beginning on Jan. 1, 2011, all brokers, transfer agents and employee plan administration agents will be required to track cost basis for certain new shares acquired after this date (“covered” shares). The purpose is to maximize accuracy in the reporting of capital gains.

The new regulations are being phased-in over a three year period. Equity securities – common and preferred stocks, exchange traded funds (ETFs), American Depository Receipts (ADRs) and Real Estate Investment Trusts (REITs) – are covered securities if they are purchased or acquired after January 1, 2011. Mutual fund and dividend reinvestment plan shares are covered if they are purchased or acquired on or after January 1, 2012. Fixed income securities (generally bonds) and options will be covered if they are purchased or acquired on or after January 1, 2013.

Before the new legislation, tracking cost basis information was the sole responsibility of the stockholder or individual taxpayer. Many taxpayers didn’t have good basis records. The purchase price of stock purchased long ago might be forgotten or not able to be proven. Stock acquired by gift or inheritance may have an unknown basis in the hands of the new owner. The IRS position on basis is that if the taxpayer cannot prove the basis, the IRS is entitled to assume that the basis is zero.

Beginning in 2011, this burden will be shifted from the individual to the brokers and agents for certain new stock acquisitions and will make it easier for taxpayers to accurately report capital gains or losses upon the sale or other disposition of shares.

Note that shares originally acquired prior to 2011 are “noncovered” securities and stockholders are still responsible for maintaining the cost basis records for these shares.

Brokerage houses and other financial institutions are informing their customers about the new rules and establishing procedures for complying with the regulations. In general, when you sell shares in your securities account, you will have choices about which tax lot to sell. Different institutions will allow various options, so you must check what the options will be where your stocks are held. Here are some examples of options that may be available: (1) you designate the specified lot of shares that you wish to sell ( a lot is a block of shares bought on a particular date in a particular transaction); (2) the earliest shares acquired will be considered to be sold first, called first in, first out, or FIFO; (3) the last shares acquired will be considered to be sold first, last in, first out, or LIFO; (4) shares with the lowest cost basis will be sold first, known as worst in, first out, or WIFO; and (5) shares with the highest cost basis will be sold first or HIFO.

If you make no selection, the regulations require the institution to establish FIFO as the default rule. After a tax lot is sold, the new regulations prohibit changing that selection after the trade’s settlement date. That means that when a sale is made, the taxpayer must select a method, and if not, the default rule applies.

A “wash sale” is when a stockholder sells stock at a loss within 30 days prior to or after a purchase of the same stock in the same account. If a wash sale occurs, all or a portion of the loss from the sale is disallowed for income-tax purposes and added to the cost basis of the newly acquired shares. (The wash sale rules do not apply if the stock is sold at a gain.) Beginning on Jan. 1, 2011, brokers and agents will be required to track wash sales and their impact on the cost basis of shares. It will still be the taxpayers responsibility to track and report wash sales across all accounts. Obviously, a financial institution has no knowledge of purchase or sales that occur in other accounts.