Cost Basis Update

Part of the Emergency Economic Stabilization Act of 2008 includes IRS regulations regarding how financial institutions such as broker/dealers and mutual fund companies report cost basis information to the IRS.  The mutual fund and DRIPs (dividend reinvestment plans) portion of the act has an effective date of 1/1/2012 for all new purchases.  Many companies are sending out letters asking investors to elect their cost basis method.  These letters range from confusing to downright incomprehensible.

 We will attempt to give a brief synopsis of what is going on with the caveat that a final decision should be made after analyzing your own particular tax situation or consulting with a tax advisor

 What is cost basis?

Cost basis is simply figuring out what you paid for an asset when selling.  The difference of the selling price and the purchase price is either a capital gain or loss.  The capital gain tax rate can depend on whether or not the holding period was short-term (one year or less) or long-term (longer than one year).  Currently the top long-term capital gain rate is 15% and short-term gains are taxed at ordinary income tax rates.

 What are some different ways to track cost basis?

 Average Cost–the cumulative dollar cost of purchase(s) divided by the number of shares (example below)

 First In First Out (FIFO)–selling the oldest shares first

 Last In First Out (LIFO)–selling the newest shares first

 Specific Lot Identification (SLID)–designation specific shares when selling

 High Cost First Out (HCFO)–selling shares purchased at the highest cost first

 Low Cost First Out (LCFO)–selling shares purchased at the lowest cost first

 I’ve sold shares in the past and paid capital gains, what is the difference now?

 Most mutual fund companies have been providing cost basis information to their shareholders on a consistent basis since the late 1990s.  The difference is that this reporting was supplied as a courtesy to the shareholder and not reported directly to the IRS.  It was ultimately up to the taxpayer to provide cost basis information to the IRS.  These rules were enacted to bring some uniformity to the industry and ensure accuracy on individual tax returns.  The IRS was also concerned about uncollected revenue.

 What should I do?

 From the sample of letters that have been issued so far it appears that the Average Cost method is the default choice for most companies and the method that was used for most shareholders prior to the legislation.  Since shares purchased before 1/1/2012 are not included (deemed non-covered shares) there is a compelling case to continue with the average cost method because the non-covered shares will often be tracked using this method.  You should call your advisor or investment provider directly with any questions regarding your specific options and how to make your election.

 Average Cost Method Example

 Investor Jane Doe purchased shares of Mutual Fund ABC over a three-year period.  Each time she made a purchase of $5,000

Date                Purchase Amount     Share Price    Number of Shares     Avg. Cost
 
2/5/2005          $5,000                         $12.00/share            416.667
 
3/15/2007        $5,000                         $14.00/share            357.143
 
11/25/2008      $5,000                         $10.00/share            500.000
 
TOTAL           $15,000                                                    1273.810               $11.776/share

 On 11/14/2011 Jane decided to redeem $5,000 from her Mutual Fund ABC.  At the time the share price was $15.00/share so she redeemed 333.333 shares.  Since the average cost of shares purchased was $11.776/share her basis would be $3,925.33 (333.333 shares x $11.776).  The difference of the redemption of $5,000 and basis of $3,925.33 would be taxed as a long-term capital gain since the shares were held for more than one year.

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