Avoid new tax paperwork for your investments at your own peril

NEW YORK Tue Nov 29, 2011 2:18pm EST

Documents are seen at the Institute for National Remembrance, which oversees communist-era files, in Warsaw February 14, 2007.

Documents are seen at the Institute for National Remembrance, which oversees communist-era files, in Warsaw February 14, 2007.

NEW YORK (Reuters) - It's not just holiday cards and sales flyers cluttering your mailbox: There's a good chance you've also been getting lots of unfamiliar paperwork about your investments. New tax rules require your broker and mutual funds to keep track of the cost of your investments for tax purposes (termed the cost basis), and they are writing now to ask you to choose your accounting method.

Ignore those new forms at your own peril, even if you'd rather ignore all the legalese. There is real money to be saved by choosing the right accounting method, and if you don't make a choice, your broker or fund company will choose a method for you. It may not be the best one.

Here's a brief explanation: When you sell a security that you've made money on, you usually have a taxable capital gain. (None of this applies to trades in tax-deferred retirement accounts.) To determine the right amount of the gain, you have to have a starting figure -- the so-called cost basis that includes the amount you spent on the securities in the first place, including commissions. That's the number that investment companies now have to track for you, under provisions of the Emergency Economic Stabilization Act of 2008.

These rules went into effect for individual stocks in 2011, so you'll be seeing that data on 1099 forms your broker sends you in January and February. In 2012 it becomes effective for mutual funds.

Calculating that cost basis may seem simple, and it is if you only bought your shares of a security at one time on one day, and you sell them all at once. But if you've been steadily buying shares of a mutual fund or reinvesting dividends by buying new shares, and then you only sell a partial stake, how do you decide which shares you are selling and how much they cost? Hence the new accounting choices.

This matters because different ways of calculating cost basis -- and there are many ways of doing so -- may mean wildly different tax bills for the same transaction. What you thought was a loss for tax purposes might even become a gain. This includes first-in, first-out (meaning the shares you bought first you sell first), last-in, first-out (meaning those you bought last you sell first), average price (for funds only) and more. You can even identify specific shares to sell whenever you make a sale.

You can choose different ways of calculating cost basis for different investments, but you cannot change your accounting choice after you sell the shares because the broker or fund company will report your gain or loss to the IRS based on that method. If you don't make a choice, the firm will simply revert to its default method, often a first-in-first-out approach for stocks or an average for funds. "I don't think clients are even aware of what the default rules are," says Mark Nash, personal financial services partner at PricewaterhouseCoopers in Dallas.

A LITTLE MATH

How much difference does this make? Let's say, for example, that you purchased 1,000 shares of JPMorgan Chase stock, in the wake of the financial crisis in early 2009, at $16 a share, and subsequently bought another 1,000 shares at $40. If you sold 1,000 shares at a recent price of $29, what's your tax hit?

If you used FIFO, you've got a gain of $13 a share, or $13,000, and a tax hit of $1,950. But if, for accounting purposes, you sell the shares you bought more recently at $40, you have a loss of $11 a share, or $11,000, which you can use to shelter gains elsewhere in your portfolios.

WHAT TO DO WITH THE FORMS

The 1099s you'll start receiving for 2011 will show your cost basis for stocks purchased after January 1, 2011, and sold during the year. Pay close attention as this has been a big scramble for all brokerage firms, and there's likely to be some errors. You also may get some surprises, as the broker's way of calculating your tax hit may not be what you expected.

Brian Keil, director of cost basis and tax reporting at Schwab, says the firm is preparing for an avalanche of calls from among its 3.2 million clients. "There's going to be a big 'aha' moment, and there will be some tears," he says. "We are preparing for a very disruptive tax season."

For active traders, one of the biggest gripes is that wash sales -- in which you're prohibited from claiming a loss on a stock if you buy a like replacement within 30 days before or after the sale -- are now reported. Many brokers, Schwab included, have set FIFO as their default; while this is often a good tax choice over the long term, if you kept buying as share prices declined after 2008, it's likely not your best bet.

While you can't retroactively change the method used, if you don't like the result you can choose a new method going forward. There are no simple rules that apply for everyone on how to choose the best cost basis. It depends whether you have other investment losses in your portfolio, how often you trade and whether you are the type of investor who tends to buy additional shares as prices rise or fall. For a more detailed analysis of your tax situation, software programs like NetBasis (www.netbasis.com) can help.

PLANNING FOR 2012

Many more investors will be affected in 2012, when the rules become effective for mutual funds. Tax rules permit fund investors to use average cost basis, a method not permitted for stock investments. As with stocks, if you don't want the default, you need to let your fund company know before you sell any shares.

Since every fund company chooses its own default method, you may end up with different cost basis accounting methods for the funds in your portfolio. Many fund companies, including Schwab and Vanguard, use the average method as the default. Sequoia, on the other hand, has picked the high-cost method -- which will tend to minimize taxes -- as its default. "The good thing is that firms are being friendly in allowing you a wide range of options," says PwC's Nash. "It is a really good opportunity for you to sit down and review what sort of default mechanism makes sense for you."

There is one additional wrinkle if you use the average as default, as many buy-and-hold investors do for simplicity. If you previously used the average method, you will now have two averages, rather than one, to account for both the shares covered by the new rules and those that are considered uncovered (because they date before the legislation went into effect). "Normally, the two would have merged together, but now they are segregated," Schwab's Keil explains. "Because the average uses FIFO automatically, any sale will come from the uncovered shares first automatically." (Got that?)

ADDITIONAL COMPLEXITIES

If you inherited any shares since the beginning of 2011, make sure that your broker knows, so that you're sure to get the correct "step-up" in basis -- in which the cost of your investment for tax purposes is valued at the time of death -- which is to your tax benefit. If you hold investments through a family partnership, contact a tax advisor now. Suffice to say those situations can get extremely complex.

So if you're getting unwanted cost-basis paperwork in the mail, deal with it now so you can enjoy the holiday season.

(Editing by Jilian Mincer and Linda Stern)

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