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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Tuesday, October 26, 2010

Good News for Some, Bad News for Others

For those who have struggled while preparing their tax returns to determine the cost basis of investments sold during the tax year, there’s good news on the way. For those who cheat on their returns, it will soon be more difficult to fudge on the gains they’ve received.

In 2008, new rules were passed by Congress that will require investment companies to track the cost basis of their customers’ assets and report them to the IRS on form 1099, when those assets are sold. The new rules will be phased in starting this coming January.

Many investors have difficulty determining the cost basis of investments they have sold, in part because they have not kept good records. In some cases they have the data but don’t understand how to accurately calculate the cost basis.

Cost basis is generally not an issue in retirement accounts such as IRAs and 401(k)s, since distributions from those accounts are typically all taxable at ordinary income tax rates. (Note that after-tax contributions to 401(k) accounts and non-deductible contributions to IRAs require special handling when taking distributions).

Gains from the sale of taxable assets must be classified based on how long the asset has been held as either a long-term or short-term capital gain. Long-term capital gains are currently taxable at the maximum rate of fifteen percent. Short-term gains are taxable as ordinary income.

Re-investment of dividends and capital gains are often handled incorrectly by investors when preparing their tax returns. Re-investments add to the original cost basis of an asset and are taxed in the year received. If the cost basis is not adjusted upward for the amount of re-investment, an investor will end up paying taxes twice on the re-invested amounts. The new rules will help investors avoid this problem.

Many investment companies have been keeping track of investors’ cost basis for some years now. Starting in January, they will all have to do so, when they will have to keep track of the cost basis data for newly acquired stocks (both domestic and international) and real estate investment trusts (REITs). Mutual funds will have to start keeping track of the data, starting in January of 2012.

While the new rules make things easier for investors, they will still have to pay close attention to cost basis issues. Assets acquired prior to January 2011, that are not held in an account at a firm that has been tracking cost basis, will still require that you do your own calculations. And, assets for which you have multiple lots will require you to specify which lot or lots you are selling. Those bought at lower prices will generate higher capital gains taxes. You may need to specify which shares you are selling if you want to minimize the taxes.

In summary, it will eventually be easier to determine your cost basis for asset you acquire in the future. For those you already own, the burden still falls on you.


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