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« I considered the Schedule D as the last bastion of the Honest John system. » Nico Willis, chief executive of NetWorth Services

Robert Neubecker • New York Times ,

New laws take guesswork out of investment tax liability

  • Article by: Tara Siegel Bernard
  • New York Times
  • March 30, 2013 - 9:12 PM

Until recently, the tax man rarely held you accountable for how much you profited — or lost — when you sold stocks or mutual funds.

Instead, reporting those numbers on your tax return was generally based on the honor system: You reported how much you bought the stock for, and if you lost track or couldn’t remember, you made your best guess. The tax collectors didn’t have an automated way of checking your calculations.

Those days are over, at least in part. For the second consecutive tax season, a new law requires your investment brokerage firm to report to the IRS the price you paid for certain taxable investments, known as your cost basis, a figure that also takes into account items like reinvested dividends, stock splits and company mergers. With your cost basis in hand, you can then figure out how much you’ve gained or lost when you sold the investment, which is then reported on the Schedule D tax form.

“I considered the Schedule D as the last bastion of the Honest John system,” said Nico Willis, chief executive of NetWorth Services, a company based in Phoenix, that calculates cost basis for investors. “The spotlight is now on, and as a result, that is making things a lot more complicated because you just can’t guess anymore.”

The new reporting rules, signed into law as part of the big bailout legislation in 2008, are being phased in over a few years and don’t necessarily apply to all of your taxable holdings: banks and brokers were required to begin tracking and reporting the cost basis of stocks in taxable accounts bought in 2011 or later. Mutual funds, dividend-reinvestment plans and certain exchange-traded funds purchased beginning in 2012 are subject to the new rules. That means this is the first tax year these funds will be reported to the IRS. Reporting for bonds and option contracts doesn’t begin until next year.

Technically, the changes should eventually make it easier to figure out capital gains or losses. But for now, you’re more likely to be befuddled by the fact that the sale of some of your taxable investments is covered, while the sale of others is not, though all of this is broken down on your 1099-B tax form prepared by your bank or brokerage firm. Given the added complexity, tax experts suggest going over everything carefully to avoid setting off an IRS inquiry.

“If you bought a mutual fund 10 years ago that you are still holding onto and reinvesting the dividends, you will have a combination of covered and noncovered securities,” said Joel Dickson, a tax specialist at Vanguard. “It can be a little confusing. And the onus is still on the investor to report their cost basis, regardless of whether it is covered or not covered” by the new rules.

The new rules will also require you to pay closer attention to which specific shares you want to sell. Before, most investors just waited until tax season to select which lots, or groups of shares purchased in the same transaction, they sold first. (Even though, technically, they were supposed to decide at the time of the sale.) And, naturally, they would pick the ones that would be best for their tax situation. Now, you need to decide how you want to calculate your cost basis within three days of the trade settling, tax experts said, and brokerage firms including Vanguard and Charles Schwab said they would lay out the choices at the point of sale.

The method you choose can have a pretty drastic impact on your tax bill, at least in some cases. Let’s say you bought $1,000 of Bank of America stock, or about 62 shares, back in August 1980 (a predecessor to today’s company was then known as NCNB Corp.). And assume you reinvested all dividends back into the same stock. Now, almost 33 years later, your stock holdings are worth about $19,000. If you sold $10,000 of the stock earlier this month, or about 830 shares, you would have the option of generating a giant gain, or a big loss, all depending on what method you use. For instance, if you sold the oldest shares first, you would log a capital gain of more than $7,100. But if you sold the newest shares first, you could post a loss of more than $14,000, according to calculations by NetBasis, the unit of NetWorth Services that provides cost basis calculations for investors.

If you don’t pick a specific method, most brokerage firms will revert to their default, whereby they sell your oldest shares first, known as first in first out, or FIFO.

“When people buy stock over time, FIFO may not be the best option,” said Thomas Cooke, a tax and business law professor at Georgetown University’s McDonough School of Business. “That makes it very incumbent on investors when they get their confirmation statement to make sure the right stock was sold.”

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