Executive Summary
On October 3, 2008, then-President Bush signed into law the Emergency Economic Stabilization Act of 2008. Although it was widely known as the "bailout" bill - it was the legislation that authorized the Treasury Secretary to use $700 billion under the Troubled Asset Relief Program (TARP) - the legislation also contained a number of measures to help bring in additional revenue to the Federal government.
Amongst those provisions was the establishment of a new requirement for financial intermediaries to track and report cost basis on securities transactions to the IRS on an updated Form 1099-B, to better ensure that taxpayers properly their gains and losses on investments and pay taxes as appropriate, and the new rules took effect for stocks that were purchased in 2011. Over the long run, the new rules will make it easier for clients to track the cost basis for most of their investments, simplifying reporting and preparing returns during tax season.
However, in the near term, the introduction of cost basis reporting brings new complexities and challenges to manage. To help support taxpayers through this process, the IRS has revamped Schedule D, and introduced the new Form 8949 - which may have to be done three times for many individuals! - for reporting capital gains and losses for the 2011 tax year.
Covered versus Noncovered Securities For Cost Basis Reporting
In order to be subject to the new cost basis reporting rules, securities have to be so-called "covered securities", which means they were purchased after certain effective dates. The effective dates are:
- January 1, 2011 for equities
- January 1, 2012 for mutual funds and dividend reinvestment plans
-January 1, 2013 for all other financial instruments, including bonds, commodities, options, derivatives, etc.(implementation delayed)- January 1, 2014 for "simple" debt securities (e.g., fixed rate bonds, original issue discount [OID] bonds, zero coupon bonds) and options, rights, and warrants
- January 1, 2016 for "complex" debt securities
Thus, any stocks purchased in 2011 (or later) are covered securities for which cost basis will be reported when sold (as will the sales of any mutual funds purchased in 2012, and other securities purchased in 2013 2014 and 2016). The reporting for sales of covered securities occurs on the new Form 1099-B, which was due to be mailed out to taxpayers last week (with copies to the IRS due by the end of the month).
However, the reality is that until many years from now, some or all investment sales will not be covered securities. Stock sales in 2011 were only covered securities if they were bought in 2011; sales of stocks that were purchased earlier (i.e., before the January 1, 2011 effective date) do not have cost basis reported on Form 1099-B (instead, for such "non-covered securities", only the sale date and gross proceeds are reported, and it's up to the taxpayer to determine cost basis). Moreover, mutual funds, bonds, and other financial instruments hadn't even reached their effective dates for the 2011 tax year, and consequently none of them were covered securities. Even by 2016, when the rules will have been in effect for 5 years, many investors will still have non-covered securities for investments that were purchased before the effective dates that still have not yet ever been sold.
New Schedule D and Form 8949
To handle these new complexities, the IRS has revamped Schedule D. On the old version of Schedule D, the taxpayer simply reported short-term capital gains and losses in Part I, and long-term capital gains and losses in Part II. If there were more investments than there was space to report them, the taxpayer attached Schedule D-1, which simply provided more room to report sales under Parts I and II (for short-term and long-term holdings, respectively), creating a running list of any/all additional investment sales and their associated purchase date/sale date/cost basis/sales prices and the total gain or loss.
On the new version of Schedule D, there is no direct reporting of investment sales and their associated gains or losses. Instead, reporting for individual investment positions occurs on the new Form 8949. While similar to the old Schedule D-1, with lines to list a series of investment positions that were sold, and separate Parts I and II for short-term and long-term positions, there are some notable differences. The first and most significant difference is that for both Parts I and II of Form 8949, the taxpayer must indicate if the form is: 1) for transactions reported on Form 1099-B with basis reported to the IRS (i.e., for covered securities); 2) for transactions reported on Form 1099-B but basis not reported to the IRS (i.e., for non-covered securities); or 3) for transactions that do not fall in categories (1) or (2) (e.g., sales of personal property not subject to Form 1099-B reporting at all).
Thus, if an individual has both sales of covered securities and sales of non-covered securities, a separate Form 8949 must be completed for each category, for both short-term and long-term capital gains. If the individual also has any capital gains or losses that are not subject to Form 1099-B reporting at all (i.e., category 3), then a third Form 8949 must be completed.
So what about Schedule D? Under the revamped process, Schedule D is now simply used to total the sales reported from each of the three categories of Form 8949s for both short-term and long-term positions. Which means in practice, you'll fill out all of the Form 8949s for covered securities, non-covered securities, and anything else (if necessary), and only then go back and complete Schedule D.
Reporting Covered And Noncovered Securities On Form 8949
The one other notable change under the new reporting rules is that on Form 8949 (which otherwise mirrors the old Schedule D-1), there are two new columns. Column (g) is used to report any adjustments to cost basis, which may occur if you believe that your cost basis on a covered security was different than what the financial intermediary reported on Form 1099-B. The second addition is column (b), where you must enter a "code" to explain why you made an adjustment in column (g); the list of the 10 available codes is provided on page 10 of the instructions to Schedule D and Form 8949, and includes "B" (the cost basis on Form 1099-B was incorrect), "T" (the type of gain/loss {whether short-term or long-term} on Form 1099-B was incorrect), "H" (a portion of the gain from your personal residence sale is excludable from income), "S" (you sold qualified small business stock under Section 1202 and can exclude some of the gains), etc.
The good news is that for many, these details regarding the new Form 8949 and Schedule D, including the required multiple versions of Form 8949, will be completed by tax software or a tax preparer, relieving the individual of some of the complexity. Nonetheless, it is important to understand the issue conceptually, especially regarding the separation of covered and non-covered securities, as those investment sales must be reported separately even via the tax software or through the tax preparer. And proper separation is important, as the IRS receives its own copies of Form 1099-B, and can compare the sales of covered and non-covered securities to what is reported on your tax return; expect an inquiry from the IRS if the totals don't match.
In addition to these reporting rules, it's also important to note that the new cost basis reporting rules for covered securities require a proper method of accounting for partial sales. The default is average cost for mutual funds (and ostensibly also for ETFs organized as '40 act funds), and FIFO (first-in, first-out) for everything else. However, in practice most taxpayers will likely want to use either higher cost or lowest cost, depending on whether they wish to harvest capital gains or capital losses. Unfortunately, though, when a sale occurs, the method of accounting is locked in by the settlement date of the transaction, and you can't change it later (and more recently there have been further proposals to limit the use of specific share identification). For a further discussion of the implications of cost basis reporting, see the December issue of The Kitces Report, which is available as a Sample Report right now.
Eventually, the new cost basis reporting rules will likely make the preparation of the tax return easier. Virtually all investments will be covered securities, reported on Form 1099-B, and can simply be copied directly to a single Form 8949. Until then, though, where taxpayers own a mixture of covered and non-covered securities, there will be more complexity. But it's important to get it right, because the whole point of this new process is that now, the IRS can check your math.
(Editor's Note: This post was included in Tax Carnival #99: Daylight Tax Time.)
