Starting January 1, 2012 new cost basis reporting changes will take effect regarding mutual funds, ETFs, and DRIPs (Dividend ReInvestment Plans). Under the new changes, the IRS will require all brokerages and fund companies to track the purchase and sale price of these assets. These are similar to the cost basis changes for stocks that were put into place at the beginning of 2011.
Cost basis, if you’re not familiar, is the original value (purchase price) of an asset. This value is used by the IRS to determine your capital gains (losses) when you sell shares in a mutual fund, ETF, or stock. Which is why it’s so important to track your investment purchases and sales closely. Using a simple spreadsheet covering: purchase date, invested amount, shares purchased, and sales date, will get the job done.
Which Shares Will Be Impacted?
Every time shares of a stock, mutual fund or ETF are purchased, that transaction is given a share lot ID, also referred to as a tax lot ID. Even if you already own shares, each new purchase is given a separate share lot ID. If you invest money every month into a specific mutual fund, there will be separate share lot IDs for every purchase.
Starting in 2012, all new share purchases in non-retirement accounts will be affected by these cost basis reporting changes. Any shares bought prior to January 1, 2012 will not be affected by these changes. The reason retirement accounts are excluded from the changes is due to the tax advantages of those accounts.
Cost Basis Accounting Methods
There are several cost basis accounting methods to choose from. Which one is used will depend entirely on your individual situation. The cost basis method you choose will have to be done at the time of sale or by the settlement date of the trade.
- Average Cost – usually the default cost basis method, found by dividing the total invested amount by the number of shares held.
- First-in, First-out (FIFO) – sells the share lot you bought first.
- Last-in, First-out (LIFO) – selects the most recently bought share lot for sales.
- Highest Cost – selects the highest price share lot for sales.
- Lowest Cost – selects the lowest price share lot for sales.
- Specific Lot – you choose the specific lot at the time of the sale or, at the latest, by the settlement date of the trade.
Any shares bought prior to 2012, are restricted to average cost, FIFO, or specific lot methods. There may be additional costs involved with share purchases and sales such as load fees or commissions that can be added to the cost basis. Each broker and fund company has a default cost basis method if no method is specified at the time of the sale. Check out our previous post for a more thorough explanation of each cost basis method.
Why Are The Changes Important?
Which cost basis you choose to use at the time of the sale will have an impact on the amount of taxes you pay at the end of the year. This is especially important if you’re selling a portion of the total shares owned.
This is why it’s important you know how to calculate cost basis. Lets say you decide to buy 100 shares of mutual fund XYZ over the course of three months. The first month you buy 100 shares at $12 each. The second month you buy 100 shares at $10 each and the third month you buy 100 shares at $14 each. After a few months shares of XYZ are at $15 each and you decide to sell 100 shares to lock in some profits. You now have a decision to make. You can pay taxes on the profits from the $12 shares ($300 profit), the $10 shares ($500 profit) or the $14 shares ($100 profit). I’d rather pay the lowest possible taxes, choosing the $14 share lot.
The method you choose will depend on the profits (or losses) from other sales and the tax code at the time. Which, again, brings up the importance of keeping your own thorough records of every transaction. Even if your fund company or broker does it for you.
Other Changes Coming In 2013
There are already additional changes in the works for 2013. We are currently in the second year of a three year rollout of reporting changes. Starting in 2013, similar changes in cost basis reporting will go into effect for options and fixed income securities. If you use these types of investments, you might want to start planning ahead.