The rules are changing, and specific-share identification offers the highest level of control.
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By Christine Benz | 03-26-12 | 06:00 AM | Email Article

In the past, there was a substantial "squish" factor when tracking and reporting cost basis--essentially, the price shareholders paid for their investments in their taxable accounts--which in turn affected how much they owed in investment-related taxes. Investment providers didn't have a direct line to the Internal Revenue Service; instead, shareholders were responsible for tracking and reporting their own cost basis.  

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Yet the honor system also left open room for investors to pay less in taxes than they should have, which is one reason things are changing. New cost basis rules began going into effect last year and will be rolled out on a staggered basis through 2013. Under the new system, brokerage firms and mutual fund companies will be required to track and report shareholders' cost basis directly to the IRS; investors will no longer serve as the middlemen. Brokerage firms began tracking cost basis for stocks in 2011, mutual fund cost basis reporting has gone into effect this year, and similar rules for tracking cost basis for bonds, options, and other securities will go into effect at the beginning of 2013. Note that the new rules only apply to securities purchased after the dates the rules went into effect; for stocks purchased before 2011, funds bought before 2012, and other securities acquired before 2013, the onus will remain on shareholders to track and report their own cost bases.

I wrote about the new rules back in October, just as mutual fund companies began sending out cost-basis election forms. At the time, I reviewed some of the chief methods that one might use to track cost basis. But if you haven't been paying attention and haven't yet made cost-basis elections, I'm here to remind you to do so. That's because firms will use a "default" cost basis election if you do nothing. If you sell shares without overriding the default, you could end up paying more in taxes than you otherwise would. The cost of being lazy about cost-basis elections seems particularly high right now, given that the markets have generally been trending up as the new regulations have gone into effect.

What's So Bad About Default Elections?
For most firms, the default method used will vary by investment type. My informal survey of fund providers shows that averaging remains the default cost basis method for funds, whereas brokerage firms are generally using first in/first out, or FIFO, as their default for customers who don't specify an alternative method.

The averaging method is straightforward; the firm arrives at the average by adding all of your purchases together and dividing by your total number of shares. FIFO, meanwhile, means that the first shares you purchased are the first ones assumed to be sold.

Depending on your situation, however, those defaults might not be advantageous from a tax-savings perspective. Say, for example, you purchased 100 shares of a fund at $8 apiece, 50 more at $10, and 50 at $12 each. Your average basis is $9.50 (your $1,900 in total purchases divided by 200 shares). If you sold 50 shares at $13, you'd be on the hook for $3.50 per share ($13-$9.50), or $175, in capital gains.

Had you been using the specific-share-identification method, by contrast, you could cherry-pick the most advantageous lot of shares to sell. Using the above example, you could instruct your brokerage firm to sell the shares you paid $12 apiece for, meaning that you'd only be on the hook for $1 per share in capital gains, or $50.

The FIFO method that's the default for stocks traded at most brokerage firms can be even more onerous in an up market. Let's say you purchased 200 shares of a stock at $6, another 300 at $8.50, and 200 more at $11 per share. If you wanted to trim your position by 200 shares when the price was $12, and you were rolling with your brokerage firm's default cost-basis method--FIFO--the firm would automatically sell your $6 shares, resulting in a capital gain of $6 per share, or $1,200 total.

The specific-share-identification method, meanwhile, would have allowed you to instruct the broker to sell your $11 shares, resulting in a capital gain of $1 per share, or $200 total.

The specific-share-identification method can be advantageous for both stockholders and fundholders in down markets, too, allowing you to specify which lots to sell in order to generate the highest possible tax loss. (Tax losses can be used to offset capital gains or up to $3,000 in ordinary income.)

What Are You Waiting For?
The new rules give you substantial latitude. For example, you will be able to select different cost-basis methods for different accounts, and you'll be able to reverse their cost-basis elections before you redeem shares. Unfortunately, you can't retroactively change your cost-basis election after you've made a trade. If you haven't overridden the default cost-basis method before selling your shares, the default is the one you'll have to use, even if it's more costly from a tax standpoint.

As the preceding examples illustrate, the specific-share-identification method gives investors the most flexibility to reduce their investment-related taxes. And now that firms are required to track your cost basis for you, using the election method of your own choosing, one of the key impediments to the specific-share method has ebbed away: keeping elaborate spreadsheets to document what you bought and when. True, you'll still be responsible for tracking the specific price you paid for shares acquired prior to the new rules going into effect, but you'll be able to lean on your financial-services providers' documentation thereafter. If you haven't yet filled out your cost-basis election form, go online and do so today. It could save you some dough come tax time.    

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