Top 5 Issues with Cost Basis

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If you’re an average taxpayer now’s the time of year that you’re frantically inputing information into Turbo Tax in an attempt to do your taxes yourself.  While we commend your can-do spirit, changes in the tax code for 2011 could leave you open to penalties if you don’t understand a little thing called cost basis.

Cost basis?  What’s that you may be saying?  Well what it is is the cost of an investment when you purchased it.  Doesn’t seem so tough you say?  Well, add in dividendens, stock splits, spin-off companies and mergers and acquisitions and suddenly it is.  And this year the IRS is cracking down on wrong reporting which could cost you thousands.

The new laws in place require that your broker provide you with the cost basis of any stock purchased AFTER Jan. 1, 2011.  Great, but what about all those investments you bought prior to last year?  Well, it’s your job to figure out the cost basis of those.  Confusing isn’t it?

Here’s the Top 5 issues surronding the changes in the cost basis laws:

1. Taxpayer Responsibility — Covered vs. Non-Covered:

Investors are still responsible for accurate reporting of their cost basis for the entire holding period of a security regardless of how far back the purchase was made, even though brokers are only held to reporting cost basis for the “covered” periods (January 1, 2011 going forward).

2. Minimizing Tax Responsibility – Sales Method Selection vs. Default Method:

Investors only have three days after a security is sold to select the most advantageous sales method for their tax strategies. If the investor doesn’t specify a preference the brokerage firm is allowed to use their default sales method, which is usually FIFO (First-In-First-Out), which is often not the best option for minimizing capital gains tax liabilities.

3. Don’t Rely on the Broker – Wash Sales:

When a security is purchased and then sold at a loss, and within 30 days a substantially identical security is repurchased, a wash sale violation has occurred and the loss allowed must be added to the replacement purchase and an accurate cost basis can be properly determined. As per the new tax law, the broker is not responsible for reporting the cost basis for wash sales when the purchase or sale date of the security that triggered the wash sale violation is considered to be “non-covered.” Also, taxpayers are responsible for reporting wash sales of identical as well as similar securities across the same account, different accounts, and even different brokerage firms.

4. Gifting & Inheriting Securities:

The Cost Basis legislation states that brokers do not have to report the cost basis on gifted or inherited securities. They are only responsible for providing the fair market value. The adjusted cost basis for securities that were acquired either as a gift or through inheritance must be reported by the taxpayer. There are very complex IRS business rules that apply specifically to the sale of gifted or inherited shares and the accuracy of the adjusted cost basis could be compromised if these business rules are not properly applied.

5. Repercussions – Fines & Penalties for Incorrect Cost Basis Reporting:

Citing ignorance isn’t going to fly.  Incorrect calculations submitted to the IRS could result in fines up to $1,000 per occurrence. If the IRS determines that an investor knew of the law’s requirements, but acted with “willful disregard,” they could be fined up to $5,000 per occurrence.

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