Planning with the New Cost Basis Reporting Rules

In November of 2010 I wrote an article that discussed the new cost basis reporting rules that began to take effect for stocks in 2011 and will expand to include mutual funds beginning in 2012.  The article explained that these rules will require you to declare a standing order on which shares of stock you want to sell before you sell them.  This is a VERY important part of this new rule and I think it needs further clarification.

Right now, if you sell shares of stock or mutual funds, you need to calculate the gain or loss by subtracting the price you paid for the shares (your cost basis) from the proceeds you received when you sold the shares.  When you sell all the shares you own of a particular holding this is fairly easy.  It gets a little trickier when you sell only a portion of the shares and the shares were bought at different times.  In this case you would need to figure out which shares you are selling so that you can calculate their basis.

There are many different methods of assigning cost basis to shares that are sold, such as FIFO, LIFO, highest cost, lowest cost, and average cost.  Typically people would wait until they were filing that year's tax returns before deciding on a method so that they could use the most tax efficient cost basis.  This was never really an "allowed" way of determining cost basis because you were supposed to assign basis to the shares at the time of sale.  Of course there was never a way for the IRS to tell when the basis determination had been made... until now.

Now that the IRS has mandated reporting of cost basis by custodians, you will have to determine a cost basis method by the settlement date of the trade.  If you do not choose a method, the custodian will choose their default method for you and you will be locked in to that method.  And you will be locked in to that method for all the remaining shares of that holding in that account!

This can have a major impact on both your tax planning AND your investment planning.  Often times people will sell shares of an investment that have an unrealized loss in order to take that loss to offset any gains and reduce their taxable income.  Now imagine you sold some high cost shares of an investment in order to realize a loss.  If you don't make the election with the custodian to use the "highest cost shares", they will use the default method, which in the case of mutual funds will be “average cost”.  If there are some shares of the same investment in that account with a lower cost basis, the average cost method could end up giving you a much lower basis and completely undermine your tax planning strategy.

There are many intricacies to these new rules but suffice it to say that this is something that all of you should keep in mind when selling any investments going forward.  We recommend you contact us or your investment custodian to be sure you are clear on the rules before completing a sale.  If you have an investment manager executing trades for you, be sure they are taking into account the new rules as well.  

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