The new cost basis reporting rules for mutual fund transactions went into effect Jan. 1, 2012. Under these new rules, the mutual fund company will use a default method to calculate the basis of shares acquired and sold in 2012 and beyond.
Strategy: Don’t assume the default method is best for you. Analyze all your options before you sell mutual fund shares. After you complete the transaction, it’s too late to change.
In many cases, you may benefit tax-wise by using a method other than the default method.
Here’s the whole story: In the past, you could use one of several cost reporting methods to figure out the taxable gain or loss, if any, when you sold securities. Best of all, you didn’t have to make the determination until tax return time, which gave you a great deal of flexibility. There was plenty of time to assess your optimal approach for your transactions for the year.
You don’t have that luxury anymore. Under a 2008 law, which is being phased in over three years, brokers must use a default method for covered securities, unless you indicate otherwise at the time of the transaction. The new rules apply to securities acquired on or after:
- Jan. 1, 2011, for stocks, American Depository Receipts (ADRs), real estate investment trusts (REITs) and exchange-traded funds (ETFs) taxed as corporations
- Jan. 1, 2012, for mutual funds (including most ETFs) and dividend reinvestment plans (DRPs)
- Jan. 1, 2013, for all other remaining securities (e.g., options, fixed income instruments and debt instruments).
The default method for stocks acquired in 2011 and beyond is the first-in, first-out (FIFO) method. However, mutual fund companies will generally use the average cost method (see box below). Starting in 2012, you can revoke the average cost method within one year or, if earlier, by the date of the first disposition of shares. Subsequently, you may change from the average cost method at any time, but only for shares acquired after the date of the change.
Favorable tax change. Previously, once you had used the average cost method for a particular fund, you were required to use average cost for all shares of that fund ... forever. Under the new rules, you can choose another cost basis method if it suits your needs.
As of Jan. 1, 2012, mutual fund positions are divided into two separate pools of “covered” and “uncovered” shares. Shares acquired prior to 2012 will be part of the uncovered pool and the cost basis method for that pool will not change. Thus, if the average cost method applied before, it will continue to apply to that pool separate from the covered pool. Absent an election, the average cost method will be applied to the new covered pool. Brokers will track the two pools separately and will generally sell shares from the uncovered pool first.
Which cost basis method should you use for mutual fund shares? It depends. The highest cost basis method will generally create smaller tax gains or bigger tax losses that can reduce your annual tax liability. On the other hand, you might use the specific ID method to jigger the tax results to fit your current needs. Your broker or a tax pro can assist you.
If you do nothing, be prepared to go forward under the average cost method.
Tip: You may have to make an affirmative election to use a different cost method even if you’re retaining a pre-2012 method other than the average cost method. Check with your broker.
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