New Mutual Fund Cost Basis Rules

December 5, 2011

Beginning January 1, 2012 new regulations set forth by the Internal Revenue Service (IRS) will take effect. These regulations affect the way in which mutual fund companies report cost basis and gains or losses for taxable accounts. The purpose of these changes is to verify what fund companies report on their tax documents and what the individual investor reports on theirs. The IRS wants your tax documents to match those of the mutual fund company whose shares you bought or sold during the tax year.

What is Investment Cost Basis?

Cost basis is simply the price you pay for a share or asset, including any sales charge that is paid. It is used to determine if you will be paying a capital gains tax or if you will be able to deduct the loss when that occurs. Cost basis also includes any reinvested dividends and capital gains distributions.

For example, if you bought 100 shares today in a mutual fund and the per share price was $20 and you were charged $10 to buy the shares, your cost basis would be $2,010. (You would also factor in your brokerage charge to sell the shares at some point in the future.) You would use this cost basis to determine if you made a profit or loss on your investment whenever the investment is sold in the future.

If you bought at $20 per share and the shares rise to $30 per share when you sell, you’ve made a profit. Your capital gains tax would be factored off of: $3,000 (100 shares x $30/share) – $10 (selling brokerage charge) – $2,010 (initial cost basis including purchasing charge from broker). Your profit would be $980 and capital gains tax would apply to that amount.

What is Changing to Mutual Fund Cost Basis Rules?

Mutual fund companies have, in the past, only reported the cost basis to the investor and not the IRS. This will change in January 2012 and cost basis will be reported to the IRS for all shares acquired after January 1, 2012 (to be called “covered shares”). Fund companies will report this information on Form 1099-B to both the IRS and the investor.

Traditionally the cost basis has been calculated using an average cost (the average price of all shares purchased). However, investors will now have the option to choose one of seven ways to calculate the cost basis.

  • Average Cost –  typically the default method for fund companies; the average price for all the shares you currently own is calculated and used when your shares are sold
  • High Cost, First Out (HIFO) – the shares with the highest purchase price are sold first
  • Low Cost, First Out (LOFO) – the shares with the lowest purchase price are sold first
  • Specific Identification (SpecID) – the investor chooses which shares are to be sold, this determines the gains or losses for that particular share.
  • First In, First Out (FIFO) –  the oldest shares are sold first
  • Last In, First Out (LIFO) – the newest shares are sold first
  • Loss Gain Utilization – shares are sold by those with losses first and then gains last

Each company will provide you with a way to choose a method for calculating the cost basis method. Typically, if you do not make a choice, the average cost method will be chosen for you. You are given additional options so you can tweak your tax strategy moving forward. It might be beneficial for you to hold onto the shares you first purchased many years ago at a lower price while selling your most recent shares that were acquired at a higher price because your capital gains would be lower.

For example if you have been investing in a mutual fund whose price was initially $10 per share and has now risen to $60 per share, you would want to sell your $55 shares first rather than your $10 shares. The difference in capital gains could be huge. However, managing your specific shares you are selling to maximize your tax benefit requires you to be very hands on with your investments.

Covered vs. Non-covered shares

The IRS is only changing the rules for a certain set of investments. For mutual funds, the covered shares (or the shares the changes will begin impacting) are those that are acquired on or after January 1, 2012. If you invested in a mutual fund earlier than that, your cost basis rules will not change on those shares.

Does the Change Only Impact Mutual Funds?

The new regulations are impacting cost basis reporting for all securities: individual equity positions (stocks), mutual fund shares, ETFs, fixed income products, and options. However, not all of the changes are impacting all of the investments at the same time. Stocks acquired anytime on or after January 1, 2011 will be considered covered securities. Mutual funds and ETFs are considered covered as of January 1, 2012, and options and fixed income securities are covered beginning January 1, 2013.

Kevin

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Kevin

Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, ING Direct, and many others.


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