Executive Summary Although the tax laws have technically always required that, when investments are sold, the specific lots and their associated cost basis are identified to determine the amount of any gains or losses, in practice most clients have simply chosen after the fact – when the tax return is prepared – which shares were sold, selecting the lots that produce the most optimal tax result. However, under new laws coming into effect, brokers and custodians will begin to automatically report transactions – including which lots were sold, the cost basis, the amount of gain/loss, and the date of acquisition and character of the loss – directly to the IRS, with sales locked in at the time the transaction settles. As a result, clients and their advisors must make proactive decisions regarding a proper method of accounting for portfolios, or run the risk that the “wrong” lots will be sold, with no way to remedy the situation after the fact! And while the IRS does provide a default method of accounting that will apply, in reality most clients will find the default a sub-optimal solution. Which means the burden really shifts to clients and their advisors to put the optimal method in place… which first requires making the right decision about whether it’s better to harvest gains or losses in the first place, depending on the client’s situation!

The inspiration for today’s blog post are an increasing number of questions I’m hearing from financial planners about how to handle cost basis methods of accounting. As I discussed in depth in the December 2011 issue of The Kitces Report, the issue is not as straightforward as we might assume – but it requires action, because the default option provided by the IRS is probably not the best decision for most clients!

Technical Background

As a part of the Emergency Economic Stabilization Act of 2008 (EESA) signed into law by then-President Bush in 2008 (it was the legislation that authorized the $700 billion Troubled Asset Relief Program {TARP}), brokers and custodians are now required to track and report cost basis on securities transactions to the IRS on Form 1099-B, to better ensure that taxpayers properly their gains and losses on investments and pay taxes as appropriate.

Under the new rules, which became effective in 2011 for equities (purchased in 2011 or later), are now effective for all mutual fund purchases in 2012 and beyond, and will apply to most other securities (bonds, commodities, options, etc.) beginning in 2013 will phase in for “simple” debt securities in 2014 and more “complex” securities in 2016, the IRS is now required to report on Form 1099-B not only the gross proceeds of a sale, but also the acquisition date, the cost basis, the amount of the gain, and the character of the gain (long or short term). Most taxpayers just caught a glimpse of these rules for the first time earlier this year, when they had to prepare their tax returns using the new Schedule D and Form 8949, which were adjusted to account for the new Form 1099-B reporting.

Choosing a Method of Accounting

One of the important rules attached to the new cost basis reporting requirements is that when a sale occurs, the decision about which lots are sold must occur by the settlement date of the transaction (typically T+3 for stocks and bonds, and T+1 for government securities). While in reality the rules have technically always required this, in practice it will now be enforced – because the broker or custodian will record which lots were sold and the associated cost basis as of the settlement date.

This is a notable contrast to how so many clients and advisors handled the situation in the past… where they would wait until the end of the year, look at the tax situation, make a decision about which lots were sold based on end-of-year tax planning, and then update the client’s records (and the portfolio management software) with the “correct” cost basis after the fact. But with the new rules recording the lots sold and the cost basis at the time of sale, it becomes all the more important to make the right choice up front about which lots were sold, or at least what method of accounting will be used to determine which lots were sold.

In the absence of any proactive decision to the contrary, the rules specify that the default cost basis election will be average cost for mutual funds (which ostensibly would include average cost accounting for ETFs organized as ’40 act funds), and FIFO (first-in, first-out) for all other securities. Clients can always adjust this at the time of sale for any particular transaction to specify which lots in particular will be sold (as long as it is done by the settlement date for the transaction). But barring any action at the time of sale to specify individual lots, or an action to change the method of accounting, the default methods will apply.

Is The Default Method of Accounting The Best Choice For Clients?

If the default method of accounting was a good choice for clients, little action would be necessary in most situations, except for unusual circumstances where the client wanted to specify certain lots for a sale in a unique scenario. Unfortunately, though, the default method of accounting will rarely be the best choice for most clients – which puts the burden on clients, and their advisors, to select a better alternative.

In practice, most clients will likely prefer one of the two following methods of accounting:

– Highest Cost. With highest cost accounting, any time a sale occurs, the shares with the highest cost basis are sold first. In practice, this means the client will sell the positions with the biggest relative losses first, then smaller losses, then the smallest gains, and lastly the biggest gains. The highest cost methodology is in essence a classic tax minimization approach (harvest the losses first, take the gains last).

– Lowest Cost. Although somewhat counter-intuitive, for many clients the optimal cost basis method of accounting is not higher cost, but lowest cost. This methodology – which recognizes the biggest gains, then the smallest gains, then the smallest losses, and lastly the biggest losses – is an approach that maximizes the recognition of current income. While in general most clients view that as undesirable, the reality is that in a rising tax rate environment – with maximum capital gains rates scheduled to increase significantly next year both due to a change in the base rate from 15% to 20%, and the addition of the 3.8% Medicare unearned income contributions tax for affluent clients – the optimal strategy is actually not to harvest the losses, but to proactively harvest the gains.

Notably, neither of the prescribed defaults of FIFO nor average cost is particularly effective produce either these tax minimization or gains harvesting maximization results. While in some cases FIFO may harvest the gains first – simply because the oldest shares often have the lowest cost basis as long as the market goes up on average – it’s not assured that FIFO will harvest the desired shares. And of course, if the client doesn’t wish to harvest gains but instead wants to minimize taxation, FIFO may yield undesired results, unless the earliest shares were bought just before the investment unexpectedly dropped. Furthermore, either way, average cost on mutual funds is even less likely to yield any desired result, as the average cost will never solely harvest the highest or lowest cost shares.

If the client bought all the shares on the same date, and/or sells all the shares on the same date, the cost basis method of accounting doesn’t matter, because any/all lots lead to the same result. But when there are multiple lots with different cost bases, and a partial sale occurs, the matching of purchased lots to sold lots matters, and having the right method of accounting is crucial to getting the desired tax outcome… especially since it can’t be corrected after the fact.

Changing The Method of Accounting For Portfolio Investments

The good news is that under the new rules, it’s easy to change the method of accounting. Just notify the broker or custodian of what the new method will be for all future sales. In the past, taxpayers had to contact the IRS to request permission for a change in method of accounting, but no longer. The change can be made directly, without prior IRS approval, as many times as are desired. The only restrictions are that mutual fund shares already partially sold under average cost must stick to average cost for the remaining shares (but can still change for new shares purchased in the future), and that sales that have already settled cannot be changed after the fact. (And of course, older securities purchased before the effective dates and not covered under the new rules are not reported on at all, and are still up to the taxpayer to report.)

In practice, this means that for most advisors, clients need to be separated into two groups: those who would benefit from harvesting gains (who should choose lowest cost), and those who would prefer tax minimization (who should choose highest cost). Once the clients are separated into groups, the advisor can work with each client to make the appropriate cost basis method of accounting change for all taxable investment accounts. Some brokers and custodians even have more sophisticated options, such as “tax sensitive highest cost” that harvests short-term losses before long-term losses, or “tax sensitive lowest cost” that harvests long-term gains before short-term gains; these differences vary by vendor, though, so some due diligence will be required about the options available for any particular client.

But the bottom line is that under the new rules, making a proper cost basis method of accounting decision is important, because it will be tracked and reported to the IRS, and cannot be changed after the fact. And in light of the fact that the default method of accounting prescribed under the law is not likely to be optimal for anyone, now is the time to make the right proactive decision for the future.

So what do you think? Have you addressed cost basis method of accounting issues with your clients? Which method did you select? Did any problems arise when making the method of accounting decision? Did you have any problems with the method of accounting that applied to any stocks purchased and sold last year?