What does cost basis mean?
A simple idea…
For tax purposes, the “cost basis” of a security is usually the original cost of acquiring it – the purchase price plus any commissions or fees related to acquiring it. Cost basis is used to compute capital gains or losses. The gain or loss is the difference between the sales price, net of sales commissions or fees, and the cost basis. So: capital gain or loss = sale proceeds – cost basis.
… is often complex in practice.
This simple idea, however, rapidly becomes more complex for certain transactions: dividend reinvestments, wash sales, return-of-capital distributions, stock splits, ESOP transactions, and corporate actions such as mergers, spin-offs, and acquisitions. These can be even more challenging for foreign securities.
In addition, for some securities the law gives investors options (besides the default “first-in, first-out”, or FIFO method) in how they compute the cost basis when they sell part of a holding, provided that they notify their broker. The investor can specify a particular lot or sub-lot to sell (this method is sometimes called “paired-lots,” “share identification,” or “versus-purchase”), and the broker needs to be in a position to record that choice and close (and report) the chosen lots. Mutual funds may report and adjust cost basis using an average-cost formula. ;
Finally, still different cost basis rules apply to securities acquired by gift or inheritance. In the case of inheritance, the “stepped up” cost basis may be the fair market value on the date of death, but in some cases an estate executor may elect a different valuation date.
For tax purposes, the “cost basis” of a security is usually the original cost of acquiring it – the purchase price plus any commissions or fees related to acquiring it. Cost basis is used to compute capital gains or losses. The gain or loss is the difference between the sales price, net of sales commissions or fees, and the cost basis. So: capital gain or loss = sale proceeds – cost basis.
… is often complex in practice.
This simple idea, however, rapidly becomes more complex for certain transactions: dividend reinvestments, wash sales, return-of-capital distributions, stock splits, ESOP transactions, and corporate actions such as mergers, spin-offs, and acquisitions. These can be even more challenging for foreign securities.
In addition, for some securities the law gives investors options (besides the default “first-in, first-out”, or FIFO method) in how they compute the cost basis when they sell part of a holding, provided that they notify their broker. The investor can specify a particular lot or sub-lot to sell (this method is sometimes called “paired-lots,” “share identification,” or “versus-purchase”), and the broker needs to be in a position to record that choice and close (and report) the chosen lots. Mutual funds may report and adjust cost basis using an average-cost formula. ;
Finally, still different cost basis rules apply to securities acquired by gift or inheritance. In the case of inheritance, the “stepped up” cost basis may be the fair market value on the date of death, but in some cases an estate executor may elect a different valuation date.
Why is cost basis important?
Cost basis will affect the amount of taxable gain or loss that an investor will recognize.
Who is responsible for accuracy in reporting the profit or loss on a security sale?
Until now, the taxpayer has been responsible for computing and reporting any taxable gain on sales of securities. While some brokerages offer some help on a “best efforts” basis, the IRS has not required them to report this information, and most brokers avoid offering anything that could be construed as “tax advice.”
However, beginning in 2011, the Emergency Economic Stabilization Act (EESA) of 2008 requires brokers to report cost basis to customers and to the I.R.S., on 1099 Forms, for any securities acquired after the effective dates:
January 1, 2011 – for any stock not eligible for the average cost method of tax basis reporting (the “Average Cost Method”);
January 1, 2012 – for any stock eligible for the Average Cost Method (generally shares in mutual funds); and
January 1, 2013 – for all other securities, except as exempted or delayed by the Secretary of the Treasury.
Brokers are also required to provide for certain elections initiated by their customers, to receive cost basis for transferred-in securities, and to supply cost basis for holdings transferred elsewhere.
However, beginning in 2011, the Emergency Economic Stabilization Act (EESA) of 2008 requires brokers to report cost basis to customers and to the I.R.S., on 1099 Forms, for any securities acquired after the effective dates:
January 1, 2011 – for any stock not eligible for the average cost method of tax basis reporting (the “Average Cost Method”);
January 1, 2012 – for any stock eligible for the Average Cost Method (generally shares in mutual funds); and
January 1, 2013 – for all other securities, except as exempted or delayed by the Secretary of the Treasury.
Brokers are also required to provide for certain elections initiated by their customers, to receive cost basis for transferred-in securities, and to supply cost basis for holdings transferred elsewhere.
Why is there a Cost Basis reporting law?
Even the most conscientious taxpayer can have great difficulty in determining the cost basis of securities held for many years, sometimes even decades. Complex corporate actions can make this nearly impossible for the typical holder of affected securities. For everyone, both the complexity of the rules and the absence of detection mechanisms and sanctions offer an opportunity to overstate cost basis. This situation has led to the suspicion that many taxpayers overestimate cost basis with impunity. Estimates of lost tax revenue range from five billion dollars per year, to as high a quarter of a trillion dollars over ten years [1].
What is the Cost Basis reporting law? (to read the law, click here)
In response, the IRS will soon require brokers and custodians to track and report cost basis uniformly, both to their clients and to the I.R.S. The Emergency Economic Stabilization Act (EESA), requires all IRS Form 1099 filers to report cost basis on the same 1099 as they now report customers’ security sales, beginning in 2011. The 1099s must also indicate whether any reported gain or loss is short-term or long-term.
[1] See commentary by professors Joseph M. Dodge and Jay A. Soled at http://www.taxanalysts.com/www/freefiles.nsf/Files/106TN0453.pdf/$file/106TN0453.pdf
[1] See commentary by professors Joseph M. Dodge and Jay A. Soled at http://www.taxanalysts.com/www/freefiles.nsf/Files/106TN0453.pdf/$file/106TN0453.pdf