Cost Basis Reporting and Taxes

Cost basis has become a hot topic among investors and brokerage firms alike. So, what’s all the fuss about?

A new tax law took effect on Jan. 1, 2011 as a part of the Emergency Economic Stabilization Act of 2008, and it requires brokerages to report certain cost basis information to the IRS. This is a good thing for investors because it makes tax preparation easier and places more responsibility on your brokerage to accurately track your cost basis.This tax legislation impacts your brokerage account in a number of ways, so check with your brokerage to find out more. For example, Scottrade streamlined their information into an easy-to-use online Cost Basis Education.

What is Cost Basis?

Let’s back up for a moment and define cost basis. Cost basis is the original value of an asset that is used to calculate gains and losses for tax purposes. For most positions, your cost basis will be the purchase price plus any commissions, and it will be adjusted for wash sales, corporate actions and/or return of capital during the time you hold it.

Cost Basis Reporting

The new legislation rolls out in phases. This tax year, your brokerage will report to the IRS the cost basis for all equities you acquired on or after Jan. 1, 2011. These are called “covered” positions. All your other investments, including equities purchased before 2011, are considered “non-covered” positions. Equities include stocks, American Depositary Receipts (ADRs) and Real Estate Investment Trusts (REITs).

Over the next two years, other types of investments will be covered:

Where Cost Basis is Reported

Your cost basis information will appear on your Form 1099. Keep in mind that not all brokerage accounts will receive a Form 1099. To learn more about the different tax forms generated for brokerage accounts, check out last month’s blog, What to Expect from Your Brokerage at Tax Time .

 Capital Gains & Losses

Cost basis information is used by your brokerage and the IRS to calculate capital gains or losses when you close a position. Some brokerages, like Scottrade, allow you to choose how your capital gains and losses are calculated.

For example, Scottrade’s default calculation method is first-in, first-out (FIFO), which means the first shares you acquired will be the first sold. Think of it like the milk aisle at a large grocery store – the shelf is loaded back-to-front from the refrigerated room in back, so the first gallon of milk that the grocer slides into the shelf is the first one a customer sees. The first gallon of milk put in is the first gallon of milk that is taken out.

Shares of stock can work the same way. Here’s an example:

Monday:         Buy 50 shares XYZ @ $9 ($450 total)

Wednesday:   Buy 50 shares XYZ @ $11 ($550 total)

Thursday:      Buy 50 shares XYZ @ $10 ($500 total)

Friday:            Sell 50 shares XYZ @ $10 (500 total)

With FIFO, your total realized gain would be $50. The first shares you bought (50 @ $9 on Monday) would be the first shares sold. Subtract your investment of $450 from your sale price of $500, and you gained $50 on the transaction.

FIFO is one of several calculation methods your brokerage can use. Check with your brokerage to find out more about the methods available and how to set a tax strategy in your account.

To learn more about cost basis, visit Scottrade’s Cost Basis Education.

Scottrade does not provide tax advice. The material provided in this article is for informational purposes only and Scottrade is not responsible for any errors or omissions. Please consult your tax software or tax/legal advisor(s) for questions concerning your personal tax or financial situation.

Jaci Devine is a free-lance writer with experience in the financial services industry who specializes in investment education.