Until recently, the tax man rarely held you accountable for how much you profited — or lost — when you sold stocks or mutual funds.
Instead, reporting those numbers on your tax return was generally based on the honor system: You reported how much you bought the stock for, and if you lost track or couldn’t remember, you made your best guess. The tax collectors didn’t have an automated way of checking your calculations.
Those days are over, at least in part. For the second consecutive tax season, a new law requires your investment brokerage firm to report to the IRS the price you paid for certain taxable investments, known as your cost basis, a figure that also takes into account items like reinvested dividends, stock splits, and company mergers. With your cost basis in hand, you can then figure out how much you’ve gained or lost when you sold the investment, which is then reported on the Schedule D tax form.
The new reporting rules, signed into law as part of the big bailout legislation in 2008, are being phased in over a few years and don’t necessarily apply to all of your taxable holdings: Banks and brokers were required to begin tracking and reporting the cost basis of stocks in taxable accounts bought in 2011 or later. Mutual funds, dividend reinvestment plans, and certain exchange-traded funds purchased beginning in 2012 are subject to the new rules. That means this is the first tax year these funds will be reported to the IRS. Reporting for bonds and option contracts doesn’t begin until next year.
Technically, the changes should eventually make it easier for you to figure out your capital gains or losses. But for now, you’re more likely to be befuddled by the fact that the sale of some of your taxable investments is covered, while the sale of others is not, though all of this is broken down on your 1099-B tax form prepared by your bank or brokerage firm. Given the added complexity, tax specialists suggest going over everything carefully to avoid setting off an inquiry from the IRS.
The new rules will also require you to pay closer attention to which specific shares you want to sell.
If you don’t pick a specific method, most brokerage firms will revert to their default, whereby they sell your oldest shares first, known as first in first out. (This applies to stocks and exchange-traded funds. For mutual funds, the default method is a bit different; they use the average cost of the shares held.)
‘‘When people buy stock over time, FIFO may not be the best option,’’ said Thomas B. Cooke, a tax and business law professor at Georgetown University. ‘‘That makes it very incumbent on investors when they get their confirmation statement to make sure the right stock was sold.’’
Finally, there’s another wrinkle to the new rules: Brokers are also required to report what’s known as wash sales. That is when you sell a security at a loss and buy the same investment within 30 days before or after the initial sale. (The firms will only be required to report wash sales within the same account, even though they are not allowed across all accounts. If it occurs elsewhere, it is up to you to report.) It’s easy to inadvertently run afoul of these rules if you’re automatically putting money into similar investments in other accounts, or you’re reinvesting dividends. And if you do, that means you won’t be able to take the deduction, specialists said, at least for now.
Given all of the changes and ample room for confusion, many of the brokerages now have areas dedicated to cost basis reporting on their websites, and some provide detailed instructions on how to change your cost basis method for subsequent sales (though, if you already sold mutual funds using the average cost method, you must stick with that strategy for remaining shares, one specialists said. But you could use a different method for new purchases). The good news is that if you decide to change brokers, they are now required to send your cost basis data to the new firm within 13 days, according to Schwab, so long as they have that information.
Meanwhile, as a result of the new rules, the IRS updated the relevant tax forms and added a new one. The 1099-B, the tax form sent by your broker that summarizes the proceeds from the sale of your investments, will now include your cost basis, sale price, and the date you acquired them. Make sure there are no errors and the information matches your records. You will still need to transfer that information to the Schedule D, which you submit with your federal tax return, but now you will also have to fill out a new 8949 form, where you must list individual transactions. You can expect to hear from the IRS if your figures don’t match their records, specialists said.
‘‘Before the new rule, the IRS had no clue what my basis was,’’ Cooke said. ‘‘It had no idea what I paid for it and relied on the investor to be honest. Now, there is no wiggle room.’’