IRS Cost Basis Reporting Rules

Cost Basis Reporting Regulations

The Emergency Economic Stabilization Act of 2008 includes reporting requirements for financial institutions. Under the revised IRS regulations, which began with the 2011 tax year, financial institutions must report to the Internal Revenue Service on clients' Forms 1099-B not only gross proceeds, but also the cost basis for covered securities sold, and whether the related gain or loss is long-term or short-term.

In addition, the legislation created a number of regulations surrounding many other organizational actions such as what is reportable to the IRS, how specific tax lots are chosen for disposition, and how accounts and individual securities are transferred – just to name a few. The following information goes into more detail on these and many other regulatory changes that affect you.

Calculating Cost Basis
Covered/Non-Covered Securities
Tax Lot Relief Methods
Closing Lot Information by Settlement Date
Account Transfer Changes
Corporate Action Reporting Changes
Wash Sale Reporting Changes
Short Sale Reporting Changes
S Corporation Reporting Changes
Changes to Tax Packages and Tax Forms

Calculating Cost Basis

Cost basis is the original value of a security for tax purposes — usually the purchase price. The cost basis for a security may also be adjusted for stock splits, nondividend distributions (return of capital), and other corporate actions. This value is used to determine the capital gain or loss, which is equal to the difference between the asset's cost basis and the sale price of the closing transaction.

Covered/Non-Covered Securities

The cost basis reporting requirements to the IRS apply only to the disposition of covered securities that occur on or after their effective date. A covered security is the type of security purchased or acquired on or after its effective date as determined by Congress and the IRS. The legislation is rolling out in three phases and started in 2011. The effective dates of covered securities are:

  • Equity securities acquired on or after January 1, 2011; mutual fund and dividend reinvestment plan (DRIP) shares acquired on or after January 1, 2012. 2014 UPDATE: Originally, all debt securities, options, rights, and warrants were to be considered covered securities as of January 1, 2014. Because of the complexity involved in accurately reporting cost basis information for debt instruments, the IRS has divided the reporting requirements for these securities into two separate phases.
    • Phase I: Simple debt securities such as fixed-rate bonds, original issue discount (OID) bonds and zero coupon bonds, options, rights and warrants acquired on or after January 1, 2014
    • Phase II: More complex debt instruments acquired on or after January 1, 2016

The new default elections for debt securities included in the IRS regulations pertain to the treatment of bond premium amortization, market discount accrual, and original issue discount accretion. For simple bonds purchased on or after January 1, 2014, it will be assumed the client has made the following elections:

  • Current amortization of taxable bond premiums
  • Deferred inclusion of market discount as income to the date of sale or redemption
  • Computation of market discount accruals under the straight line method

If, after consulting with a tax advisor, your client wants to change these default election methods, it will require a written request. Note: Election and/or default methods for debt securities purchased prior to December 31, 2013 will not change.

Remember that transactions involving assets purchased and held prior to these effective dates, or non-covered securities will continue to be reported as they have been in the past, meaning only gross proceeds will be reported by Wells Fargo Advisors. Wells Fargo Advisors will NOT report cost basis information to the IRS on non-covered security sales. It remains the clients' responsibility to report non-covered security transactions along with the proper cost basis on tax returns to the IRS.

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Tax Lot Relief Methods

Selecting a tax lot relief method is a way of setting a default for determining the selection of which lots of a security will be liquidated first in a given transaction. In addition to selecting which lot of a security will be sold, it also identifies its associated cost basis and holding period which are used in computing the gain or loss and whether or not it is long-term or short-term.

When using specific tax strategies, clients need to be aware of the tax consequences of their trading activity throughout the entire year. There may be benefits to using a different tax lot relief method in different accounts or in the sale of some specific covered positions. As in the past, clients can choose a specific tax lot to close even if they have set a specific tax lot relief method as a default and instruct their Financial Advisor to execute the closing transaction using the "versus purchase" method. Clients should consult with their tax advisors to determine the best tax lot relief method for their needs.

  • Default tax lot relief method.
    The IRS requires that all firms establish a default tax lot relief method to determine cost basis on all accounts in the event a client does not determine a specific tax lot relief method. Consistent with current Federal income tax regulations, Wells Fargo Advisors is using the default tax lot relief method of First In First Out (FIFO).
  • Available tax lot relief methods.
    Wells Fargo Advisors now offers a number of tax lot relief methods to assist clients with their tax strategies. Contact your tax advisor for the tax lot relief method that would best serve your needs.

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Closing Lot Information by Settlement Date

Once a specific tax lot has been sold, federal tax regulations prohibit the firm or the client from changing that selection after the settlement date. Federal tax regulations mandate the enforcement of this deadline so cost-basis information reported by the firm on a Form 1099-B for a covered security can be matched to the cost-basis information reported by taxpayers on their federal income tax returns.

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Account Transfer Changes

In the event of an account transfer to another financial institution, the delivering firm must provide accurate cost basis information to the receiving firm for all covered securities including partial transfers, free deliveries and physical transfers. This information must be provided within 15 calendar days of the account transfer. If the delivering firms know the lots to be non-covered, they are not required to send the receiving firm that information.

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Corporate Action Reporting Changes

Financial institutions are required to adjust cost basis of covered securities based on issuer corporate action reporting. IRS regulations require issuing corporations to provide shareholders with the applicable tax consequences necessary to adjust cost basis information, or post that information on their web site in lieu of notifying each shareholder directly.

Shares received in a corporate action event where tax information was not provided by the issuer will result in tax lots without a cost basis. Subsequent sales of those tax lots will result in financial institutions reporting a gain equal to the full amount of the proceeds (i.e., the cost basis information will equal zero).

Foreign corporations that are not subject to U.S. tax laws are not obligated to provide U.S. tax implications on their corporate actions. Therefore, the inability to determine cost basis in new shares, rights, warrants, etc. will occur most often in those circumstances.

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Wash Sale Reporting Changes

When a stock is sold at a loss, the IRS allows the loss to offset capital gains you might have. Excess losses may be used to offset ordinary income up to $3,000. The exception to this is a "wash sale" (PDF). If the same or substantially identical stock is purchased 30 days before or after the sale, the Federal tax code does not allow current recognition of that loss. This prevents you from selling the stock, taking the deduction and then buying it back within the wash sale time frame to capture any future gains. The wash sale rule can also be triggered by multiple purchases on the same day if one of those tax lots is sold within 30 days for a loss.

For securities with the same CUSIP number, financial institutions are required to monitor and report wash sales that occur in the same account. They will not be required to track replacement shares if there are substantially "identical" but have different CUSIP numbers, purchased at another institution or even purchased in another account at the same institution. You are required to monitor wash sales across all accounts — including across institutions or among spousal and other accounts — and comply with the requirements regarding wash sale positions.

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Short Sale Reporting Changes

Prior to the revised regulations, short sale transactions were reported to the IRS in the year the position was opened. As of 2011, short sale transactions are now being reported in the year that the position is closed.

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S Corporation Reporting Changes

S Corporations now receive consolidated year-end 1099-B forms which will be reported to the IRS.

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Tax Packages and Tax Form Changes

IRS Schedule D of the Form 1040 has been reformatted and the new IRS Form 8949 has been added. This new form includes a column to report adjustments to cost basis information we have provided as well as codes to explain the reason for the adjustment. You should consult with your tax advisor regarding any adjustments, such as where the issuing corporation has not provided tax consequences of a corporate action.

Changes in the IRS forms have prompted Wells Fargo Advisors to make enhancements to the supporting documentation provided to you. For example, the Realized Gain/Loss information in your year-end tax package has been reformatted to more closely align with IRS Form 8949 which provides the information that flows through to the new IRS Form 1040 Schedule D.

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IRS Cost Basis Reporting Frequently Asked Questions

General Overview
Debt Security Elections
Tax Lot Relief Methods
Trading

General Overview

What is cost basis reporting?
The Emergency Economic Stabilization Act of 2008 included new tax reporting regulations for financial institutions. Under the Internal Revenue Service (IRS) regulations, which were effective with the 2011 tax year, financial institutions must report the adjusted cost basis of covered securities to the IRS on Form 1099-B.

What is the Emergency Economic Stabilization Act of 2008?
In 2008, Congress passed the Emergency Economic Stabilization Act or, as it is better known, the TARP Bill which was enacted in response to the emerging credit crisis. Embedded within the laws in the EESA were provisions for the new IRS-mandated cost basis reporting regulations for financial institutions.

What is a covered security?
The IRS has defined a covered security as any security purchased or acquired for cash on or after specific effective dates. A security is also considered covered if it is transferred to a subsequent account from another account in which it was a covered security. The effective dates are as follows:

  • Equity securities purchased or acquired on or after January 1, 2011
  • Mutual funds and dividend reinvestment plan shares (DRIPs) purchased or acquired on or after January 1, 2012
  • Simple debt securities, options, rights and warrants purchased or acquired on or after January 1, 2014
  • Certain "complex" debt securities purchased or acquired on or after January 1, 2016

What is a simple debt security?
Simple debt securities include:

  • fixed-rate bonds
  • original issue discount (OID) bonds
  • zero coupon bonds

What is a complex debt security?
Complex debt securities include:

  • Instruments that do not have a fixed yield and fixed maturity date
  • Instruments that provide for more than one rate of stated interest (e.g., stepped interest rates)
  • Zero coupon bonds which convert to interest paying bonds
  • Convertible debt
  • Stripped bonds or coupons
  • Instruments that require payment of principal or interest in a non-U.S. currency
  • Certain tax credit bonds
  • Instruments with a payment-in-kind feature (where the instrument may be redeemed for additional debt of the issuer)
  • Instruments of a non-U.S. issuer
  • Instruments issued as part of an "investment unit" (i.e. investments with more than one component such as a forward contract combined with a bond)
  • Contingent payment debt instruments
  • Variable rate debt instruments
  • Inflation-indexed debt instruments

Debt Security Elections

What are the default elections for debt securities?
For simple debt securities purchased on or after January 1, 2014, it will be assumed the client has made the following elections:

  • Current amortization of taxable bond premium
  • Deferred inclusion of market discount as income to the date of sale or redemption
  • Computation of market discount accruals under the straight line method

May I choose to use election methods different from the IRS default election methods?
Yes. You may choose to use different election methods related to the calculation of amortization and/or accretion of debt securities held in your account. According to IRS regulations, this will require written notification by you to your Financial Advisor. Once your Financial Advisor receives this notification, the election methods can be changed. It is recommended that you speak with your personal tax advisor as Wells Fargo Advisors cannot provide tax advice to clients. Note: Changing this election with Wells Fargo Advisors does not constitute changing the election with the IRS.

What if I choose to not make any different cost basis elections for debt securities?
If no different election methods are chosen and presented to your Financial Advisor in writing, the calculations of cost basis for covered debt securities will be made in accordance with the IRS default election methods.

Do the cost basis calculations on debt securities that I held prior to January 1, 2014 now change to the new default elections?
No. Election and/or default methods for debt securities purchased prior to December 31, 2013 will not change. However, if you do want to change the election methods already in place, it will require written notification by you to your Financial Advisor. Once your Financial Advisor receives this notification, the election methods can be changed. Note: Changing this election with Wells Fargo Advisors does not constitute changing the election with the IRS.

Where can I find more information on elections related to amortization of bond premium and accretion of discount?
You can find more information in IRS Publication 550 entitled Investment Income and Expenses (Including Capital Gains and Losses). This publication discusses requirements and available elections for amortization of premiums and accretion of discounts on debt securities and is available at irs.gov/publications/p550. You can also contact your Financial Advisor for more information. It is very important to review your elections with your tax advisor, or consult this IRS publication, to help ensure your elections are consistent with the regulatory requirements.

Tax Lot Relief Methods

What is a tax lot relief method?
A tax lot relief method determines which lot of stock or securities - and its associated cost basis - is used in computing the gain or loss on a sale and whether that gain or loss is long- or short-term.

How many tax lot relief methods are available from which clients can choose?
There are eight available tax lot relief methods from which clients can choose as their standing tax lot relief method. These methods are as follows: FIFO (First In First Out), LIFO (Last In First Out), HIFO (Highest In First Out), LOFO (Lowest Cost First Out), HCST (Highest Cost Short Term), HCLT (Highest Cost Long Term), LCLT (Lowest Cost Long Term), and LCST (Lowest Cost Short Term).

What does designating a specific tax lot relief do?
The designation of a specific tax lot relief method on an account acts as a standing order, of sorts, that automatically determines the order in which specific positions are sold. For example, if an account has a FIFO (First In First Out) designation, the positions that were purchased first will be sold first. If an account has a LIFO (Last In First Out) designation, the positions that were acquired most recently would be the first to be sold.

What if I don’t designate a tax lot relief method when opening a new account?
If you don't designate a specific tax lot relief method, the account will be set up using the firm default of FIFO (First In First Out) consistent with federal regulations.

Will I be able to designate a specific tax lot relief method for existing accounts?
All accounts opened prior to January 1, 2011 were opened using the firm's FIFO (First In First Out) default method unless the client specifically requested a different method. If you wish to designate a different tax lot relief method for any of your accounts, please contact your Financial Advisor.

Trading

If I want to designate a specific tax lot after a trade is executed, is there a deadline to correct the trade/reporting information?
If the incorrect lot of a security is sold, you have until settlement date (T+3) to notify your Financial Advisor to correct the trade. After settlement date, the trade will stand as is.

What happens if I don’t realize that the incorrect tax lot of a covered security has been sold until after settlement date?
IRS regulations clearly state that specific share designation must be made by settlement date of the closing transaction. After that time, the trade must stand as is.

More questions? Please contact your Financial Advisor.

Cost Basis Glossary

Automated Customer Account Transfer Service (ACATS): An automated system developed by the National Securities Clearing Corporation (NSCC) that facilitates the transfer of securities from one trading account to another at a different financial institution.

Cost Basis: The value of an asset for tax purposes (usually the purchase price) adjusted for stock splits, dividends, and return of capital distributions. This value is used to determine the capital gain or loss, which is equal to the difference between the asset's adjusted cost basis and the asset's sale price. Also known as "tax basis."

Covered/Non-Covered Indicator: A notation on client statements that indicates whether the tax lot is covered under IRS cost basis legislation.

Covered Security: A covered security is any security purchased or acquired on or after the effective date as designated by the IRS.

  • Equity securities acquired on or after January 1, 2011
  • Mutual fund and dividend reinvestment plan (DRIP) shares acquired on or after January 1, 2012
  • Debt securities, options, and all other financial instruments acquired on or after January 1, 2014 (The IRS has extended this date from the previously announced date of January 1, 2013.)

Disallowed Wash Sale Amount: The amount of a loss that cannot be realized for tax purposes due to a wash-sale violation. The disallowed wash-sale amount value is included as an adjustment to the basis on the trade that triggered the wash sale violation. See Understanding Wash Sales (PDF) for more information.

Default Tax Lot Relief Method: A firm-chosen default tax lot relief method is designated for any account that does not specify a particular method at account opening. Consistent with current Federal income tax regulations, the firm has elected to use the default tax lot relief method of First In, First Out (FIFO).

Dividend Reinvestment Plan (DRIP): A plan offered by a corporation that allows investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date.

Emergency Economic Stabilization Act of 2008: In 2008, Congress passed the Emergency Economic Stabilization Act. Embedded within the laws in the Stabilization Act were provisions for the new IRS-mandated cost basis reporting regulations for financial institutions.

Frozen Tax Lots: Securities purchased or gained through reinvestment programs by a financial institution where the cost basis can be verified are considered frozen. (Covered securities are automatically considered frozen securities.)

Gift Date: The date on which the tax lot was transferred into the account as a gift.

Gift Fair Market Value: Fair market value of a tax lot transferred into an account as a gift. The fair market value (FMV) of a stock or bond is the mean between the highest and lowest selling prices quoted on the valuation date. The valuation date could be the transfer date or the as-of date, if used.

Non-Covered Security: Any security purchased or acquired prior to the covered security effective dates is considered non-covered. Assets purchased and held prior to these effective dates will have only gross proceeds on realized gains/losses reported to the IRS.

Open Date: Date on which the tax lot was purchased or transferred into an account.

Original Open Date: Original open date of the tax lot.

Reconciliation: Reconciliation is the matching of a taxpayer's gains and losses on Schedule D of his 1040 with the financial institution's 1099-B.

Short Sale: A short sale occurs when a client sells securities which he does not own. The transaction is considered closed when the client purchases the shares to close out the position. Short sales are reported in the year in which the position is closed.

Step-Up: A term used when transferring securities that refers to the process of adjusting the cost basis of a tax lot to the current market value on the date of transfer or the as-of date, if used.

S-Corporation: A type of corporation that meets the IRS requirements to be taxed under Subchapter S of the Internal Revenue Code. This provides a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. This means that any profits earned by the corporation are not taxed at the corporate level but, rather, are taxed at the level of the shareholders.

Tax Lot: A tax lot is the record of a taxable purchase date and cost for a specific security transaction. This provides the shareholder with the option of specifying exactly which shares to sell at a later date in order to possibly reap a tax advantage.

Tax Lot Relief Method: A tax lot relief method determines which lot of stock or securities -- and its associated cost basis -- is used in computing the gain or loss on a sale and whether that gain or loss is long or short term.

Term: Indicates the holding period for capital gains/losses. Long-term holdings are more than one year. Short- term holdings are less than one year.

Unit Cost: Cost per unit for each tax lot (total cost amount divided by quantity).

Versus Purchase (VSP): Clients may select specific tax lots to be closed by sale order on a transactional basis to affect a "versus purchase" trade on specific transactions, if desired. These instructions should be provided by the client to the Financial Advisor at the time of order acceptance.

Wash Sale: A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale. For example, when you:

  • Buy substantially identical stock or securities
  • Acquire substantially identical stock or securities in a fully taxable trade
  • Acquire a contract or option to buy substantially identical stock or securities

See Understanding Wash Sales (PDF) for more information.

Wells Fargo Advisors does not provide legal or tax advice. Although this information is not intended to replace discussions with your tax advisor, it may help you understand the tax implications to your investment plan effectively going forward.

 
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