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New Cost Basis Reporting Presents Opportunity For Investors

February 15, 2012


As tax forms were received throughout January and February, the studious investor may have notice that tax form 1099-B that reports proceeds from security sales looks quite different this year than in years past. Due to the Emergency Economic Stabilization Act of 2008 and in an effort to reduce under-reporting of capital gains, custodians of investment accounts were required to begin reporting cost basis information to the IRS for the 2011 tax year.

Previously custodians provided gross sales information only without cost basis on form 1099-B. The taxable gain or loss is the difference between the amount received from the sale and the cost basis of the shares sold. Cost basis information may have been provided as a convenience to account owners, but this was not reported to the IRS. 

These new reporting requirements are being implemented over a period of years. Stocks were included under the new reporting requirements starting in 2011, mutual funds in 2012, and bonds and options in 2013.


Are You “Covered”


One of the more confusing aspects of the new cost basis regulations is the concept of covered and uncovered shares. Even though stocks are part of the new reporting requirements for 2011, the rules only apply to stocks that were purchased and sold after January 1, 2011. For example, 100 shares purchased in January 2011 and later sold in December 2011 would be covered. However, if the purchase date was February 2010, then the shares would be uncovered. This is relatively straightforward for stocks but will become more confusing with mutual funds, particularly if you choose to have distributions from the fund reinvested.

For example, suppose you purchased a fund in January 2011 and then reinvested quarterly dividends throughout 2011 and 2012. When you sell this fund the original 2011 purchase and 2011 reinvested dividends would be considered uncovered. However, the 2012 reinvested dividends would be considered covered and reported to the IRS. Custodians will be required to track the two pools separately and will generally sell from the uncovered pool first.

“Lots” of Options


The cost basis of shares is determined by the custodian’s default method unless a taxpayer elects another method.  There are several choices. Choices include average cost, FIFO (first in first out), LIFO (last in first out) or specific identification.  Selecting specific share lots will always yield the best potential result.

Default cost basis methods are generally FIFO for stocks and average cost for mutual funds. Under prior law, once the average cost method was applied to a particular mutual fund for a particular taxpayer, the taxpayer was required to use average cost for all shares of that fund forever.  Under these new rules, taxpayers now have an unprecedented to choose a more favorable cost basis method.


Tax differences resulting from the varying methods can be illustrated from the information in the table. Suppose over a two-year period, purchases of ABC company stock were made, and the taxpayer is in the 28% tax bracket. 800 shares of ABC need to be sold and taxes paid are to be minimized.

Under the FIFO method, 800 shares from tax lot one are sold and a long-term gain of $20,000 is realized. Federal taxes will be due at a 15% tax rate and total $3,000.

Under the specific identification method, the taxpayer instead chooses to sell 400 shares from tax lot three for a short-term gain of $2,000 taxed at the 28% ordinary income tax rate. This results in $560 in tax. 400 shares from tax lot one are also sold for a long-term gain of $10,000, resulting in $1,500 in tax. Thus the specific identification method yields total tax of $2,060 or nearly one-third less than using the FIFO method.

Implications for Investors

Tax planning for investments is likely going to increase in importance as tax rates on income, dividends, and capital gains are set to increase in 2013 unless Congress extends current rates as they did in 2010. A 3.8% Medicare surtax will also begin to be assessed in 2013 on net investment income for certain higher income taxpayers.

Even sophisticated investors often ignore tax planning opportunities they have available to minimize taxes due on their taxable investment accounts. This is in part because a disassociation exists as the taxes due on the investment account are rarely if ever paid from the investment account itself. Rather, the taxpayer receives the 1099 and pays any tax due from outside sources. 

While there are several strategies a taxpayer can utilize to minimize investment taxation, one of the basic tenants is to utilize specific lot identification as the selected cost basis methodology. Now that new cost basis regulations are being implemented taxpayers have an attractive opportunity to take a closer look and choose the method to best minimize taxes.

It is important to note that, depending on the custodian, it may be necessary to make an affirmative election to use a different cost method even if the taxpayer wishes to retain the method previously utilized.  Taxpayers should not delay in checking with their custodians to avoid any unintended changes and select the preferred method.

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.



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