Cost basis is a simple idea to understand on the surface, but becomes increasingly complicated as you dig deeper. In order to fix this, Congress did what it does best: made the issue even more complex.
The Emergency Economic Stabilization Act of 2008 included new tax reporting requirements, mandating that custodians, broker-dealers, and transfer agents report the cost basis of sold securities, and whether the gains or losses are short- or long-term, to the IRS on Form 1099-B.
The requirements are phasing in over three years. The first phase took effect on January 1, 2011, covering equities acquired on or after that date. So for any stock sold that was acquired in 2011 or later (considered a "covered" security), the cost basis and holding period will be reported to the IRS on Form 1099-B. However, for positions acquired before 2011 (an "uncovered" security), no cost basis information will be reported to the IRS.
This creates the first layer of confusion. Custodians will have to separately report cost basis for some positions, but not for all of them. Taxpayers, on the other hand, must still report cost basis for all positions, and they must do so on both a revised Schedule D and a new Form 8949 (or, usually, multiple Forms 8949).
To make matters worse, there is no standardized reporting for all custodians to follow, so taxpayers may be issued Forms 1099-B that look slightly different. Custodians must also adjust cost basis to reflect stock splits, spin-offs, mergers, name changes and other corporate actions, which can all have different effects on cost basis. Many taxpayers are finding that the information reported by their custodian does not match their personal records. Reconciling the difference and then figuring out how to report it can seem an impossible task - especially during the crunch of tax season.
Another complication as a result of the new rules is the requirement for custodians to make so-called "wash sale" adjustments. A wash sale occurs when a taxpayer sells a security at a loss, and then repurchases the same, or a substantially identical, security within 30 days before or after the sale. The idea is to avoid taxpayers capturing losses without really losing exposure to the securities in question. In a wash sale, the loss from the sale of the security will be fully or partially disallowed, and the cost basis and holding period of the repurchased shares must be adjusted.
As many taxpayers learned this past tax season, they may trigger more wash sales then they thought. The usual culprits are reinvested dividends, which are common for long-term investors. According to the Investment Company Institute trade group, reinvested dividends accounted for almost $173 billion of the $202 billion in dividends that long-term mutual funds paid in 2011. Each reinvested dividend is considered a separate purchase, or trade lot. When reinvestment occurs within 30 days before or after shares are sold at a loss, this triggers a wash sale, often without the investor knowing it. In this case, part or all of the loss is disallowed, and the cost basis and holding period of the reinvested shares must be adjusted. The amount of the reinvested dividend, and thus the loss disallowed, is usually insignificant, but it can still create an administrative burden and lead to confusion during tax season if investors do not make regular adjustments to both their realized and unrealized positions.
The second phase of the new reporting requirements began on January 1, 2012, and covers mutual funds, Dividend Reinvestments Plans (DRIPs) and most ETFs. These securities are only considered "covered" if they were purchased on or after the effective date of January 1, 2012. So taxpayers will generally hold a mix of both covered and non-covered securities for years, until they sell all their pre-2012 positions.
The third and final phase was initially scheduled to take effect on January 1, 2013, covering other specified securities, including fixed-income and options. However, earlier this month the Internal Revenue Service announced that it will postpone the effective date for this third phase until January 1, 2014.
The new reporting rules are part of the government's effort to reduce the estimated $385 billion annual tax gap, which is the amount of taxes estimated to be owed versus the amount actually paid. According to the Joint Committee on Taxation, the new cost basis reporting requirement is estimated to raise $6.7 billion over a decade - or about 0.17 percent of the tax gap over the same time period. Thank you, Congress; now you can focus on the other 99.83 percent.
Before the new rules, the IRS only required custodians to report information about gross proceeds from sales of securities. Taxpayers were responsible for tracking their own cost basis, sometimes using information from their custodians or help from their accountants or financial advisers. Under the new rules, the IRS will be able to detect whether taxpayers are overstating losses or underreporting gains by comparing them with the cost basis information reported by the custodians on taxpayers' returns. If the information does not match, the IRS can issue a matching notice to the taxpayer.
While accurate reporting of costs basis is an important part of a fair and balanced tax system, the new rules have placed a significant burden on custodians, financial advisers and, ultimately, taxpayers. According to a recent article in Bloomberg BusinessWeek, custodians are spending an estimated $528 million to implement the new regulations. (1)
As the industry adapts, there may be unintended consequences that will ultimately hurt individual taxpayers and investors. Custodians' increased costs may eventually lead to increased fees and trading costs for investors. Accountants may increase their tax return preparation fees as a result of the additional forms necessary and the complexity of reconciling discrepancies in cost basis information. Taxpayers who would have otherwise prepared their own tax returns may find the new rules too confusing and, as a result, may need to hire an accountant for the first time.
A recent report from the research firm Celent explains how the new cost basis reporting requirements present an opportunity for tax firms to offer specialized services and to regain some of the market share previously lost to do-it-yourself tax preparation software. The report found that the new cost basis reporting regulations could provide an increase of $450 million annually in tax preparation fees. (2) The wealthy generally already hire accountants for tax services, so the majority of this increase will likely come from smaller, retail investors who previously prepared their own returns.
As with all regulations, Congress should consider the costs against the benefits and understand how the new rules will affect the public - especially the smaller, retail investors that make up the politically all-important middle class. Politicians always seem to promise a simpler and fairer tax code, but the new cost basis reporting rules are anything but simple.