Saturday, February 15, 2014

How to Figure Out Your Cost Basis / It's important to know when it is time to sell / Did you sell an investment held in a taxable account last year?

Laura Saunders for the Wall St Journal writes: Did you sell an investment held in a taxable account last year?
If so, prepare for a struggle—or at least a brush—with a crucial but confusing area of the tax code.
It goes by the name "cost basis," and it is the starting point for measuring profit or loss on the sale of an investment, whether it is a stock, bond, house, artwork or other asset.
Many investors find it baffling.
"If I say 'cost basis,' some people think baseball and others think chemistry class," says David Lifson, a certified public accountant at Crowe Horwath in New York. "Sometimes they just look at me like I have two heads."
Recent rule changes can make it more confusing, he says.
At its simplest, cost basis is the original price paid for an investment. If a taxpayer buys a share of XYZ Co. for $20 and sells it for $25, his cost basis is $20 and his taxable gain is $5. If XYZ's price falls to $12, his cost basis remains $20 and his loss is $8.
Yet cost basis often isn't that simple. Changes such as stock splits, reinvested dividends and even home improvements can change an investor's basis, and taxpayers who don't make these adjustments risk overpaying or underpaying Uncle Sam.
For example, if that share of XYZ going for $25 splits into two shares priced at $12.50 each, then the investor who bought it for $20 has two shares that each have a cost basis of $10.
If he later sells one of these for $22 and doesn't make an adjustment, then he would pay tax on $2 instead of $12 of gain—and be liable for unpaid taxes and penalties if the Internal Revenue Service catches him, Mr. Lifson says.
On the plus side, putting a $100,000 addition onto a home would raise its cost basis, as could reinvesting dividends from a stock or fund into new shares. Taxpayers who forget to make an adjustment when reporting a sale could overpay Uncle Sam by reporting too much profit.
Many taxpayers struggle with cost-basis record keeping, especially when it involves assets held for decades. Jonathan Horn, a CPA practicing in New York, says his toughest case involved Consolidated Edison ED +1.17% shares that had been inherited and then gifted once over four decades before they were finally sold.
"We had to use Social Security death records and old stock reports to find the correct cost, but we did it," he says.
Not all taxpayers are so diligent. "Historically, some people have been very creative" with cost basis, says Stevie Conlon, a cost-basis specialist at Wolters Kluwer Financial Services in Chicago. "If there's no one with a radar gun, some people really speed."
Experts say the IRS rarely questions or audits cost-basis data, except in abusive tax shelters. To help the confused and discourage cheating, Congress passed a law in 2008 requiring financial firms to track cost basis for certain assets and report it both to customers and the IRS after a sale.
In the short run, these rules might add to taxpayers' confusion while they phase in. For now, they cover some assets but not others. If you are facing a cost-basis conundrum, here are some tips:
Find out if your brokerage or fund firm can help.
Current law requires brokerages and fund firms to track and report cost-basis information for sales of stocks bought in 2011 and after, mutual funds and dividend-reinvestment plans bought in 2012 and after, and some bonds and options bought beginning in 2014.
Yet some firms track cost basis for assets acquired before those dates, making them a good place to start.
Be sure to correct reporting errors.
What if there is a mistake on your firm's 1099 report of cost basis to the IRS? If it is difficult or impossible to get a corrected 1099, tax pros advise reporting the erroneous information and then making an adjustment correcting it, rather than simply reporting the correct amount.
"This is what the IRS wants you to do, and it avoids a computer mismatch notice," Mr. Horn says.
Take advantage of research tools.
Some publicly traded companies offer online information about prices and splits. AT&T,-1.02% for example, has a calculator that can help people who received stock because of the firm's breakup in 1984. Companies' investor-relations departments may offer further help.
In addition, mass preparers such as TurboTax and H&R Block HRB +1.11% offer some clients access to professional cost-basis services.
If the precise date of purchase isn't clear but the year is, some preparers pick a midrange price as a reasonable estimate, especially if the total selling price is 10% or less of the taxpayer's income.
Understand the rules for inherited and gifted assets.
The cost basis of an inherited asset is usually its value on the date of the original owner's death. So if a mother bought shares of Acme Co. for $10 each that were worth $80 when she died and left them to her son, his basis becomes $80 a share. If he sells the shares for $90 each, his gain is $10 a share.
Assets received as a gift, however, retain the giver's cost basis. If the mother gives her son Acme shares selling for $80 each that she bought for $10 a share, his cost basis in those shares remains $10.
Experts say gifted stock causes many cost-basis headaches—especially when someone gave the taxpayer a few shares annually, say for a birthday, because it is necessary to know the price the giver originally paid.
Hold on or donate.
There are two tax-favored options for taxpayers who can't determine the cost basis of an asset. One is to hold it till death, when cost basis resets to the market value as of that date.
The other is to donate it to a tax-exempt charity. The donor gets a deduction for the full market value for such gifts, within certain limits, and cost basis is often irrelevant.
But what if you sold an asset before thinking it through? Says Mr. Lifson: "Pay tax on the entire value, grit your teeth and move forward."