The new “cost basis” rules may cause plenty of confusion for mutual fund investors, but they also provide a unique tax planning opportunity.
In the past, it was up to investors to account for the cost basis on Form 1040 when securities were sold. You could choose from one of several accounting methods to determine the cost basis if you acquired different lots of the same security at different times and different prices. Frequently, it made sense to specify particular lots to create a larger tax loss or a smaller taxable gain.
Under a 2008 law, your broker must now provide the pertinent cost basis information for “covered securities” on the Form 1099-Bs it sends to you and the IRS each year. But unless you specify otherwise at the time of a securities sale, the broker will use a default method for determining the cost basis—and that method may not be the most advantageous option in your situation.
The law is being phased in over three years for different types of securities. Although the new cost basis rules already apply to stocks acquired after 2010, those requirements have only started to affect sales of shares in mutual funds and dividend reinvestment plans (DRPs) acquired after 2011.
The default method for mutual funds and DRPs is generally the “average cost” method. The cost basis is determined by adding the total cost basis of all of an investor’s shares and dividing it by the total number of shares to find the average cost per share.
Effective January 1, 2012, mutual fund positions are divided into two pools of uncovered and covered shares. Shares acquired prior to 2012 will be included in the uncovered pool and the cost basis for that pool won’t change. Therefore, if the average cost method previously applied to that pool, it will continue to apply. Unless an investor elects another method, the average cost method applies to the new covered pool. Brokers must track the two pools separately and will generally sell shares in the uncovered pool first.
Previously, once the average cost method had been applied to a particular fund for a particular investor, that investor was required to use the average cost method for all shares of that fund—forever. But the new rules open up a tax planning opportunity.
At the time of a transaction, you can now opt for an accounting method for mutual fund shares other than the average cost method, if it suits your purposes. For instance, you might benefit tax-wise from the specific identification method. Note that it may be necessary to make an “affirmative election” to use a different cost method even if you want to retain a pre-2012 method other than the average cost method. We can provide guidance to help you achieve the maximum tax results under these complex new rules.