Sizing Up the New Cost Basis
The new federal rules governing cost basis reporting are a little elaborate, but the big picture is easy to grasp. Ever drive through a red light at a traffic intersection where one of those automatic cameras can snap a picture of your license plate, catching you in flagrante? The driver running the light is your investor client. The photographer is your custodian, broker/dealer, or anyone else who sends out 1099-B forms reporting trade results. After all, investors have been fudging cost basis on tax returns for years.
Starting this year, those days are over. Responsibility for cost-basis reporting shifts to broker/dealers and custodians, which will be required to start recording it in 1099-B filings for both investors and the
For financial advisors, the transition is not expected to be an easy one. Due to the way the new rules are written, advisors will need to pay close attention to which lots of any security they sell for clients, and can expect a lot of phone calls from confused customers looking for answers.
“Based on the reactions I've had at the presentations I've given, I would say many [financial advisors] really are not ready for this,” says
But procrastinating is not going to cut it, she says. “These issues are not year-end issues. They fundamentally relate to the activities you're doing every day when you're buying and selling,” she says. And advisors who aren't paying attention could get grief from clients if there are unfavorable tax consequences from the new cost-basis rules on certain trades.
Closing The Gap
The government has known for years that it was getting shortchanged on capital gains. In 2001 alone, the
“I've seen one audit in 27 years where the
Since custodians and some b/ds have tracked cost basis for their clients as a value-added service for years, legislators thought the rest of the industry should take up this burden as well so that the
Some in the industry have likened the new practice to the W2 reporting that employers must provide to the government. It comes with a price, of course. The total cost to the custodians, b/ds and others who will have to track the paperwork runs about
Setting aside the financial consequences, many financial advisors couldn't be happier with the new rules. For one thing, securities that are transferred from one advisor to another must be accompanied by a statement that outlines the cost basis; RIAs who had to track down that information in the past when bringing on new clients often found it an onerous task. Now it will be done for them by the preceding broker.
Another reason some advisors welcome the new cost basis rules involves certain dreaded conversations that tend to come up around tax time. “It's a very uncomfortable position we're put in when the client calls us and the client wants to know what to do, and what you're supposed to do and what you can get away with are two different things,” says
Still experts warn that advisors can get in trouble with their clients if they don't move proactively on the new rules. Consider these pitfalls:
- In the past, accounting methods that were used to calculate cost basis, such as first in first out (FIFO), were often selected by investors after the trade. Now, the methodology must be set before the settlement date of the trade; investors who think they can change the methodologies after the fact are in for a rude surprise. (The new law defaults to FIFO on equity trades. Different defaults can be set up, and can be overridden for specific trades.)
- Lot selection also requires some thought. If you own 1,000 shares of
XYZ Corp. that you've acquired in multiple lots over different periods of time, you can't sell 100 shares in 2011 and decide in 2012 which lot you meant to sell. The lot must be identified at the time of trade or before the settlement date.
To the discerning client, the difference will matter if the wrong lot is sold and the trade results in an inappropriate tax consequence, Conlon says. “I might yell at my advisor. I might say, ‘Dude, you told me to sell. I sold. But you didn't tell me I had to pick the lot my tax guy is telling me. And now I'm being told by my broker that it's too late. I can't change it. You cost me,’” she says.
Pershing and other custodians have been actively preparing for the coming regime change with a variety of services for their client advisors, from white papers and web-based seminars to YouTube videos and toll-free telephone help lines.
“Even if 20 percent of those folks call us, that's 600,000 phone calls potentially coming in all within a couple of weeks,” Keil says.
Keil recommends that advisors develop a strategy that meets the needs of their clients. “Because Schwab and other custodians will be communicating to the clients the changes, and you want to be able to support the questions that are going to come in to your office,” he says. “If you help support CPAs and tax attorneys on behalf of your clients, which many of our clients do, make sure they're aware of what's happening. Don't assume that because they're tax attorneys and CPAs that they know how Schwab, for example, is going to handle these exchanges. Get ahead of all this and make sure your clients are educated.”
Doing the Cost Basis Math
Here's an example of how an advisor's client can get nailed on the new cost basis rules.
Assume the client buys stock over time and wants to buy and hold. He buys 100 shares at
The client decides to sell 100 shares but wants to remain in the stock. He sells 100 shares at
The FIFO cost basis means that the lot that was bought on
For More Information
- www.costbasisreporting.com. Sponsored by
Wolters Kluwer Financial Services . A law library, sections on specific cost basis conundrums posed by the new rules, links to webinars and other useful stuff. - www.irs.gov. Type “cost basis” in the search field at the top of the page. The overview on cost basis includes 68 frequently asked questions.
- “Cost Basis Reporting: Preparing for 2012.” A 21-page
Charles Schwab white paper that includes case studies and practice management suggestions.Google it. - Fidelity Investments has reports, webinars, and videos. Google Fidelity Institutional Wealth Services and type “cost basis” in the search field.
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