Simply because we cannot get enough of taxes and the Internal Revenue Service (IRS), I’d like to take a moment and focus on how cost basis reporting (CBR) might actually work to your benefit. Let’s start with recent history.
The Great Recession compelled the federal government to get a better view into securities transactions with hopes of clarity and better revenues. And to show that it was finally paying attention. Thus was born the Emergency Economic Stabilization Act of 2008—the TARP law—and subsequent IRS regulations to enforce CBR, starting with equities. (Mutual funds, fixed income and options are also on the hook for the new, rigid rules.)
As explained to me by the patient Martin Bentsen, director of the cost basis practice at Wall Street systems integrator Jordan & Jordan, a tax lot refers to a set of securities purchased at a specific time and price and subject to taxation.
For instance, 1,000 shares can be broken down and purchased in three separate lots at different times and prices—say at $1.00, $1.25 and $1.50, Bentsen says. In the days before CBR, firms would sell a specific tax lot for the best price it could get and, if so inclined, eventually sell them all. Then the firm would average out the stock prices of these sales, taking into account all the things that can happen to a stock’s price, and use that average for tax reporting purposes. This is not so anymore.
“Now that the IRS has said it wants this tax lot tracking for cost basis purposes, brokers have to track on the lot level what was bought, what day it was bought and for how much,” Bentsen says. “And when a customer goes to sell their securities there are different methodologies they can apply.”
But there are ways to work the system. It involves new rules for “wash sales,” (which sound like discounts for your local Laundromat but aren’t) and the wise management of tax lots.
A wash sale is a way to create artificial losses usually at the end of the year to ease the tax burden. They used to be relatively easy. To get an example of the new way to record wash sales, I turn to Cameron Routh, senior vice president, managing director of strategic products at Scivantage, a trade processing and account management software provider.
Routh says that by Christmas-Hanukah-Kwanzaa-time most firms know the level of their losses and their wins. If a firm is lucky enough to have had a lot of wins, the standard operating response is to find some losses to offset them or face a rather large tax bill.
“Maybe they want to find some securities that didn’t perform so well that they still own. They will sell them, take the loss and offset the gain,” Routh says. “So the IRS implemented a wash sale rule that says if you sell something for a loss and repurchase that security … you defer the loss. And that’s a very hard calculation to make.” With CBR, firms have to identify that a wash sale has occurred, document all of its tentacles, and then do the calculations. “For heavy traders, that becomes a real challenge.”
In addition, the purchase and sales (P&S) departments of trading firms will have to get involved, Bentsen says.
P&S departments must follow new rules regarding tax losses that tie them back to customers and to fairly tedious details and record-keeping. For instance, if an investor puts in a buy for 1,000 shares, the investor can specify eight different lot executions, and can choose to sell only one of those execution lots. “This means that you have to track it down to the execution level for lot purposes,” Bentsen says. Fun times.
“And when you have breaks, your P&S department has to go back and talk to the other side or the NSCC [National Securities Clearing Corp.] to figure out what lots were and weren’t broken. It really is a web that spreads throughout the organization,” Bentsen says. (The P&S department also traditionally oversees confirmations to clients, which will also be affected by CBR. More fun times.)
Despite the red tape, there may be a rather thin ray of light via CBR. For starters, it will likely cause firms to think harder beforehand about the tax implications of their lot sales, Routh says. They are likely to become more sophisticated in this regard. So, on to another example, thanks to Routh.
Let’s say a trading firm purchases 100 shares of Apple Inc. stock at $200 apiece, then another 100 shares at $300, and still another 100 at $500. That’s three lots of a hot stock, which gives the firm several alternatives to work with when the stock price hits $450.
If the firm decides to sell the oldest lot at the $450 price point, the firm will show a gain of “$250 per share,” says Routh to the liberal arts major. “If I pick the oldest one, it’s going to have a huge gain.” Doing the math quickly, Routh points out that such a sale constitutes a gain of $25,000, which we will consider as a long-term investment, taxed at the 15% rate.
The second lot would have a gain of $150 per share and would be considered a short-term investment, taxed at an incremental rate of 35%—a rather large tax payment because the stocks have not been held for a year.
The third option is the lot purchased at $500 per share. As the going price is $450 per share, the firm would suffer a loss of $50 per share. This would seem the wiser road to take. But it’s counterintuitive for investors and firms that are wired for making gains, not losses. They may need some guidance. “When it comes to tax payments, you want to take losses,” Routh says.
Bentsen adds that firms can also choose yet another alternative. If a firm knows that by the end of the year, it is harboring a loss of $40,000 to $50,000 on a lot or two, it might want to show a gain of $40,000 or $50,000 instead because the total tax bill for those gains may only come to $3,000 or so.
“In general, cost basis is dynamic,” reminds Routh. In fact, with CBR it will get even more dynamic. “Over time, the original cost can change and not just through what you sold off.” A cornucopia of mergers, stock splits and other corporate actions can impact the cost basis calculation. “All those things will alter the cost basis of the securities you hold.”
The bottom line is that the IRS wants clarity and revenue. Some have estimated that tax revenue windfalls will range from $5 billion to $11 billion. Fat chance, says Routh, given the current tough investment environment. The revenue estimates assume that it’s been all gains, all the time for several years.
So, while it’s questionable whether the IRS will achieve new revenues, it’s likely it get more transparency into key transactions. For the firms, the CBR push has the potential to make them a lot more tax savvy.
“If I know the cost basis of each tax lot, I can be smarter and I can pick the one that’s going to have the most favorable tax outcome for me,” Routh says.
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