Are You Ready for the New Capital Gains Reporting

Starting this year, brokerage firms, banks and mutual funds are required to report to the IRS the “cost basis” of stocks and other publically-traded securities sold during 2011.  In the past “sale amounts” were reported.  The new reports will also indicate whether sales are short-term or long-term.  Only gains on long-term sales qualify for preferential capital gains tax rates.

Believe it or not, this new reporting requirement was a revenue provision in the “Energy Improvement and Extension Act of 2008”, one of five different acts which formed the “Emergency Economic Stabilization Act of 2008”, otherwise known as the “Troubled Asset Relief Program” or TARP.  Revenue provisions are the pieces of a congressional act designed to raise the money to pay for expenditure provisions in the act, the stuff that costs money.  According to Congress, the new stock sale reporting requirements will generate some 6.7 billion dollars over a ten year period.  The money is supposed to come from taxpayers who are underreporting or misreporting capital gains.  But Congress didn’t take into account what the new reporting requirement will cost the IRS to implement, what it will cost the banks and brokerage firms to administer and what it will cost investors in terms of paper, postage, accounting time, tax preparation fees and general hassle.

There are three major problems inherent in the new law.  Firstly, your stock broker doesn’t know what your cost basis is if you didn’t buy the stock from him.  Secondly, tax law provides for three different methods of computing a basis, called “first-in-first out”, “last-in-first-out” and “average cost”.  Your stock broker doesn’t know which method you’re going to use when preparing your tax return, nor should he know — it’s none of his business.  To make things more complicated, you’re allowed under the tax law to use different methods for different assets on the same tax. Which brings us to problem number three, the number of disputes bound to arise between the IRS and taxpayers when gains reported on tax returns don’t jive with gains reported on 1099 forms.  Congress didn’t figure out the cost of resolving these disputes either.

A final word of warning:  if you’re an active investor, you should expect to receive 1099 forms quite late this year.  In 2008, after the IRS significantly changed the reporting rules for reporting dividends, many brokerage firms had to send out two or three sets of “corrected” 1099 forms before getting it right.  That year, some of our clients didn’t get final 1099 forms until April.  This year could be the same.