Preparing for Cost Basis Changes

Transcription

1 211 Main Street, San Francisco, CA September 1, 2010 Preparing for Cost Basis Changes As you may know, cost basis reporting requirements are changing. New legislation passed by Congress in 2008 requires brokers such as Schwab to report cost basis to the IRS and taxpayers starting with tax year This change represents a shift in the way you and your advisor will approach cost basis. We understand that you may have questions about what this means for you and what Schwab is doing to comply. On the following pages, you ll find answers to frequently asked questions about the changes the legislation will bring, as well as charts designed to give you a snapshot of how the changes will roll out over the next three years. We ve also included an article from Rande Spiegelman, CPA, CFP, vice president of financial planning at the Schwab Center for Financial Research, explaining how the new reporting rules may benefit you. Schwab is dedicated to keeping you informed and to working closely with you and your advisor through this transition. If you have further questions or would like more information, please contact your independent investment advisor. Schwab Advisor Services TM (formerly Schwab Institutional ) serves independent investment advisors and includes the custody, trading and support services of Schwab. Independent investment advisors are not owned by, affiliated with, or supervised by Schwab Charles Schwab & Co., Inc. All rights reserved. Member SIPC. ( )

2 Contents Cost Basis Frequently Asked Questions...1 What is the new cost basis legislation?... 1 What is cost basis vs. adjusted cost basis?... 1 What are covered and uncovered securities?... 1 How does this legislation affect me?... 1 How do I account for missing cost basis on securities when I sell after the law is in effect?... 1 What is Schwab s cost basis default method?... 2 What cost basis methods are available at Schwab?... 2 When can a cost basis method be changed?... 2 How will this legislation affect wash sales?... 2 Covered and Uncovered Securities Chart...3 Sample Positions Chart...4 Calculate the Cost Before You Sell, by Rande Spiegelman, CPA, CFP...5

3 Cost Basis Frequently Asked Questions What is the new cost basis legislation? Congress passed the Emergency Economic Stabilization Act on October 3, 2008, which requires brokers to report adjusted cost basis for taxable accounts to the IRS and taxpayers via Form 1099-B starting with tax year Today, Schwab only reports gross proceeds on sales for taxable accounts. The legislation applies to securities acquired on or after the effective date as follows: January 1, 2011, for equities January 1, 2012, for mutual funds, ETFs and dividend reinvestment plans (DRIPs) January 1, 2013, for other securities (including fixed income and options) The legislation also requires that the new Form 1099-B indicate if the gain or loss is short- or long-term, and the amount of any loss disallowed under the wash sale rules. What is cost basis vs. adjusted cost basis? Original cost basis is the purchase price of a security plus commissions and other fees. The adjusted cost basis is the original cost basis and any adjustments due to wash sales, amortization and accretion, and corporate actions. Cost basis is used to determine capital gains and losses of an investment for tax purposes. What are covered and uncovered securities? Covered refers to securities acquired on or after the effective dates in the legislation (January 1 of 2011, 2012 or 2013). Uncovered refers to securities acquired prior to the effective dates. Schwab will report cost basis for covered securities to the IRS and taxpayers on Form 1099-B. Taxpayers remain responsible for reporting cost basis for all uncovered and covered securities to the IRS on their tax returns. See Sample Positions on page 4 and Covered and Uncovered Securities on page 3. How does this legislation affect me? If you acquire and sell a security in a taxable account on or after the effective date (i.e., equities on or after January 1, 2011), Schwab will report cost basis for the sold security to you and the IRS on Form 1099-B. If you have a mix of covered and uncovered positions in the same security, Schwab will report cost basis to you and the IRS for any covered positions that are sold. We will apply the FIFO (First In First Out) default method for equities unless you inform us of another preferred method. Your cost basis method for all equity transactions will be final by the settlement date. If you choose to change the FIFO default method for equities to another method, you can do so at any time by notifying Schwab. If you wish to change the method for a specific trade, you must notify Schwab of the change before the settlement date. The cost basis method cannot be changed after settlement. See the Covered and Uncovered Securities chart on page 3. How do I account for missing cost basis on securities when I sell after the law is in effect? First, determine if the security was purchased at Schwab and if the cost basis is missing. If the security was purchased elsewhere and the cost basis was not transferred to Schwab, you or your advisor should try to locate your original statements and trade confirmations or request copies from your other brokers to obtain cost basis for your securities. If you are unable to obtain the original purchase information, refer to a tax advisor or the IRS for advice. The IRS may allow the use of an estimate, such as the average for the day purchased or approximate time frame of the purchase. The IRS may require you to report zero if you can t prove the cost basis, so whenever you use an estimate, we strongly encourage you to consult with a qualified tax advisor, CPA, financial planner or investment manager. 1

4 What is Schwab s cost basis default method? Schwab s default method for sold securities is FIFO (First In First Out). The average cost method will be applied for mutual funds, but even if it is applied, lots are sold in a FIFO manner. In most cases, your advisor will select a default method on your behalf. Please contact your advisor for more information. What cost basis methods are available at Schwab? A tax lot consists of one or more shares of a security purchased at the same price on the same day. The cost basis method determines which lots are sold first. For all sold securities except mutual funds, Schwab offers the following default methods as well as FIFO: LIFO (Last In First Out): The lots you acquired last are sold first. High Cost: The lots with the highest cost are sold first. Low Cost: The lots with the lowest cost are sold first. Tax Lot Optimizer : Lots are selected and sold with the objective of taking losses first (short-term then long-term) and gains last (long-term then short-term). Specifically, lots sold are selected in the following order: 1. Short-term losses Lots that reflect a short-term loss are sold first, beginning with lots that generate the greatest shortterm loss down to the least short-term loss. 2. Long-term losses Lots that reflect a long-term loss are sold, beginning with lots that generate the greatest long-term loss down to the least long-term loss. 3. Short-term, no gains or losses Short-term lots that reflect no gain or loss. 4. Long-term, no gains or losses Long-term lots that reflect no gain or loss. 5. Long-term gains Lots that reflect a long-term gain, beginning with lots that generate the least long-term gain up to the greatest long-term gain. 6. Short-term gains Lots that reflect a short-term gain, beginning with lots that generate the least short-term gain up to the greatest short-term gain. Schwab also offers Specified Lot, which allows you to assign specific lots to be sold at the time of trade up until settlement date. Specified Lot is not a default cost basis method. For mutual funds, Schwab uses the average cost method, in which cost is derived by dividing the total dollar amount invested in a particular fund position by the number of shares held prior to the trade date. Shares are removed in FIFO order. When can a cost basis method be changed? Other than for securities using average cost, the default cost basis method can be changed at any time, and the new default will be applied for all future trades. If you wish to assign a specific lot (versus purchase) to a particular trade, you may do so at the time of trade or before the trade settles. Cost basis method for the specific trade cannot be affected after the trade settles. How will this legislation affect wash sales? Schwab will adjust losses on wash sales that occur in the same account with identical shares (same CUSIP) to the IRS. Although you are not allowed to claim the loss on a wash sale, the disallowed amount is added to the cost of the repurchased security, enabling you to recognize the loss when the security is finally sold. This rule only applies to losses. Gains must be reported even if the same or similar shares are purchased within 30 days of the sale. Schwab will be required to report the disallowed amount to the IRS. It is possible that you could have other situations that contribute to a wash sale that brokers are not required to report. 2

5 Covered and Uncovered Securities The legislation will roll out in three phases, as listed in the chart below. Covered securities are those acquired on or after the applicable dates outlined by the legislation. Securities acquired by clients before these dates are uncovered by the legislation. Brokers are not required to report cost basis on uncovered securities. Taxpayers are responsible for accurate reporting of cost basis on covered and uncovered securities to the IRS on their tax returns. Covered Securities Uncovered Securities Broker vs. Taxpayer Responsibility Brokers will report cost basis to IRS and taxpayer on Form 1099-B. Taxpayer will use Form 1099-B data in preparing their tax return filing for 2011 and following years. Taxpayer will report cost basis to IRS. Equities* Acquired on or after Jan. 1, 2011 Acquired prior to Jan. 1, 2011 Mutual funds, dividend reinvestment plan (DRIP) shares and ETFs** Other specified securities, including fixed income and options*** Acquired on or after Jan. 1, 2012 Acquired prior to Jan. 1, 2012 Acquired on or after Jan. 1, 2013 Acquired prior to Jan. 1, 2013 *Equities include corporate stock (other than stock in a regulated investment company [RIC] or stock acquired in connection with a dividend reinvestment plan [DRIP]). Internal Revenue Code section 6045(g)(3)(C)(i) provides that the applicable date is January 1, **For stock in a RIC (RIC stock) or stock acquired in connections with a DRIP (DRIP stock), section 6045(g)(3)(C)(ii) provides that the applicable date is January 1, *** For any other specified securities, section 6045(g)(3)(C)(iii) provides that the applicable date is January 1, 2013, or a later date to be determined in the future. The reporting rules related to options transactions apply only to options granted or acquired on or after January 1, 2013, as provided in section 6045(h)(3). 3

6 Sample Positions This chart shows a sample of positions as of June 30, EQUITY HOLDINGS QUANTITY MARKET PRICE MARKET VALUE ASSETS ACQUIRED UNREALIZED GAIN (OR LOSS) HOLDING PERIOD Units Purchased Cost per Share Cost Basis IBM 600 $26.00 $15, ($2,400.00) 600 $30.00 $18, /26/2001 ($2,400.00) Long-Term General Electric 4, , $ $ $415, $185, /25/2011 $11, $4, Short-Term 2, $99.47 $218, /10/2002 $6, Long-Term GE Cost Basis $403, Chevron 2, $ $250, $52, , $99.00 $198, /20/2005 $52, Long-Term Apple Inc. 7, $ $568, $88, , $ $201, /15/2011 $42, Short-Term 3, $ $245, /12/2005 $38, Long-Term Apple Cost Basis 500 $65.00 $32, $480, /26/2001 $8, Total Equities $1,250, $150, Long-Term Total Cost Basis $1,099, = Covered securities under the legislation and therefore reportable to the IRS by Schwab once sold. = Uncovered securities and therefore reportable to the IRS by the account holder (taxpayer) once sold. 4

7 Calculate the Cost Before You Sell Rande Spiegelman, CPA, CFP, Vice President of Financial Planning, Schwab Center for Financial Research In this article Rande Spiegelman explains how new cost basis reporting may help you pay less in taxes. Are you planning to sell an investment that s gone up in value? The laws for capital gains taxes are changing, so we ll walk you through what you need to know now, plus what s ahead for Currently, realized gains on stocks, bonds and mutual funds held over one year are taxed at a maximum long-term capital gains rate of 15%. 1 Short-term gains (on investments held one year or less) are subject to ordinary income tax rates. The gain is the sale price minus your cost basis, or what you paid for the investment. Calculating your cost basis can be complex, and the accounting method you use to report it can have a big impact on your tax bill. If you calculate it incorrectly, you might overstate your gain and pay more tax than necessary. The good news is your financial institution may already be tracking your cost basis for you, and your tax preparer can help. REPORTING YOUR COST BASIS When you sell a stock, bond or mutual fund in your taxable account, your financial institution reports the proceeds to the IRS, but you report your cost basis. To help you calculate that, be sure to save confirmations and account statements, which include information that shows what you paid for an investment. For mutual funds, that includes statements showing automatic reinvestments. ADJUSTED COST BASIS When you buy stocks or bonds, to calculate your initial cost basis, add any commissions and fees to what you paid. After that, the per-share cost basis may be affected by stock splits or spin-offs. A common mistake is failing to adjust your mutual fund cost basis for the automatic reinvestment of taxable distributions. The last thing you want to do is pay tax twice by forgetting to add the reinvested distribution to your cost basis. BOND DISCOUNTS AND PREMIUMS Special reporting rules govern the cost basis of individual bonds purchased at a market premium or discount. The rules are fairly complicated and affect the reporting of current income, the ongoing adjustment of cost basis and the treatment of gain or loss on the sale. Unless you re up to speed on all the rules, we recommend you have your tax preparer manage your bond-transaction documents. USE REPORTING RULES TO YOUR ADVANTAGE As you purchase investments over time, you ll likely end up with different tax lots shares purchased on different dates at different prices. If you later enter into a partial sale (sell some shares of a particular investment and keep some), choosing which shares to sell can potentially help you increase your after-tax profit. Usually, you want to minimize taxes by recognizing the smallest gain (or largest loss) possible. Alternatively, you could decide to recognize a larger gain to offset a current loss or a capital-loss carryover from previous tax years. 5

8 MAIN IRS-APPROVED ACCOUNTING METHODS Although FIFO is the IRS default method for both individual securities and mutual funds, most institutions, including Schwab, report individual securities using the FIFO default method and report mutual funds using the average cost method. COST BASIS CHANGES FOR Method FIFO First in, first out is the IRS default. For partial sales, the IRS presumes you sold your oldest shares first, unless your broker indicates otherwise. FIFO may not be ideal for everyone. If the value of your oldest shares has declined, FIFO will result in a capital loss. But if the share price has increased steadily since purchase, FIFO generally results in the biggest gain. SPECIFIC IDENTIFICATION Specific ID offers more flexibility than FIFO, but requires some up-front planning. You must identify the specific shares you re selling at the time of sale and have your broker confirm that identification in writing. Typically, your broker can add a memo line to your confirmation statement. For example, if you re selling the 100 shares you bought on March 6, 2009, have your broker write on your confirmation that the transaction is a sale versus purchase 3/6/09. AVERAGE COST SINGLE CATEGORY Most brokers and mutual fund companies keep an ongoing calculation of average cost basis for you, including automatically reinvested shares. To determine your average cost per share, add up the cost basis of your entire position and divide it by the number of shares you own. Do this prior to your first sale. Use this amount for all future sales as long as you hold the position, and adjust it for any subsequent purchases. To determine whether short-term or long-term capital gains taxes apply, the IRS presumes you sold your oldest shares first. Once you start using the average cost method for a particular fund, you can t switch to another method without IRS permission. Although this method gives you less flexibility than specific ID, it generally provides a better result than FIFO. Use for Individual securities or mutual funds Individual securities or mutual funds Mutual funds For the first time, financial institutions will be required to report cost basis information to the IRS. Beginning in 2011, financial institutions will report the adjusted cost basis information for security sales to the IRS. As always, taxpayers will need to include the cost basis information on their tax returns. The changes will apply to: Equities acquired on or after January 1, Mutual funds, ETFs and dividend reinvestment plans acquired on or after January 1, Other specified securities, including fixed income and options, acquired on or after January 1, It s still a good idea to save your purchase and sale documentation, including records of any automatic reinvestments, to make sure it matches the information that financial institutions will report to the IRS. You should also make sure your financial institution is reporting using the accounting method of your choice. LEARN MORE For detailed information on cost basis reporting, see IRS Publication 550, Investment Income and Expenses, available at irs.gov/publications. 1 Tax rates on long-term capital gains are scheduled to revert to pre-2003 law after The information provided is for general purposes only. Nothing in this article should be considered as an individualized recommendation or personalized investment or tax advice. The investment and tax strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment or tax strategy for his or her own particular situation before making any decision. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.