The New Year’s celebrations will barely be over before financial advisers face their first challenge for 2011 — new rules requiring brokerages to tell Uncle Sam how much investors paid for stocks.
The cost-basis reporting rules are designed to ensure people do not understate investment gains or overstate investment losses to minimize their taxes.
Rather than leaving it to investors to fill out the cost-basis information on their tax returns, brokerage firms will provide the information to the Internal Revenue Service. The changes are expected to generate more than $6 billion in tax revenue over the next decade but are also likely to cause confusion among investors.
“People used an ‘it’s-good-enough’ approach for the cost-basis information they provided in the past,” said Stevie Conlon, tax counsel at Wolters Kluwer. “Investors are going to be frustrated by the changes.”
The rules take effect in stages, starting with all stocks purchased on or after Jan 1. In 2012 they extend to mutual funds, most exchange-traded funds and shares acquired through dividend reinvestment programs; in 2013 they extend to fixed income investments.
Financial advisers need to be aware of three key areas that may cause confusion for clients — wash sales, lot selection and gifting securities.
Wash sales
Wash sales involve securities sold at a loss and repurchased within 30 days. Investors are not allowed to claim the “loss” as a tax deduction.
Previously, it was up to individuals to report wash sales. But now, provided the sale and repurchase were done in the same account, the brokerage firm will have to report the details to the IRS.
“It’s not uncommon for us to see far more wash sales than investors think they are incurring,” said Conlon. “They’re going to be frustrated when they’re disallowed (losses from) wash sales.”
Lot selection
Some clients may have bought stock in a company at different prices over a number of years. If the client decides to sell some of that stock, the cost basis depends on the “lot” of shares that are sold.
Previously, advisers and accountants could wait until the end of the year to see a client’s tax situation before assigning lots.
Under the new regulations, the lot must be decided by the time the trade settles, which is usually within three days. This means advisers will have to be much more conscious of the tax implications of choosing one lot over another.
Gifts
The regulations could affect securities distributed as a gift. Advisers generally value securities at their market value on the date of the gift, but things get complicated if that value is less than what the person giving the securities paid.
A father may give his son shares of Company X that he bought for $100 each. At the time he gives his son the shares, they are only worth $80 per share.
If the son then sells the shares for $90 per share, he does not get to record the loss as a tax deduction because the sale price was above the market value when he received them.
Advisers will need to keep track of the carry-over cost-basis value as well as its market value.
These rules have been in place for years, but many investors failed to comply with them.
“Before, the investor just decided whether they would follow the rule or play the audit lottery and just skip it,” said Conlon.
While the changes for advisers and firms come into force next year, the confusion for clients is likely to come in 2012, when they receive their first 1099 forms under the new scheme.
Charles Schwab Corp. has changed the design of its 1099s to accommodate the new information. Given that Schwab sends out 3 million of these tax forms each year, including around 800,000 through affiliated financial advisers, the firm plans to gear up for plenty of phone calls, said Brian Keil, the firm’s director of cost-basis reporting.
“Even if 10 percent of people call with questions, that’s 300,000 people calling, probably within a few days of each other, and needing a lengthy explanation,” he said.
