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Cost Basis Reporting: The Gift That Keeps on Giving

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Cost basis reporting continues its march to full implementation. To refresh your memory, the IRS started tracking corporate stock purchases as of Jan. 1, 2011. They then added ETFs, mutual funds and S-corporations purchased as of Jan. 1, 2012. This year, options and some bonds are now part of the cost basis reporting rules.

All options acquired as of Jan. 1, 2014, are now part of the cost basis reporting rules. The types of bonds that are included are a little more complex. Simple debt instruments were the first type of bonds to be added to the cost basis reporting rules, including bonds based on a single fixed payment schedule where the yield and maturity is determined. This also includes debt instruments that involve a demand loan where the yield can be determined or that involve a call or put option that allows the bond to be called before expiration.

Given the complexity of cost basis reporting for bonds, there are multiple factors for advisors to consider when selecting an appropriate accounting method. Bonds are very different from and more complicated than equities and mutual funds, so calculating cost basis for federal income tax purposes is also complex. Therefore, you and your client’s tax professional are the best individuals to make these decisions.

You must make these accounting method decisions specifically for bonds prior to Dec. 31 in order for these instructions to apply in 2014. Also, keep in mind that your custodian has a default accounting method in place if you do not make a specific selection. It is important to make sure that their systems reflect any changes to the accounting method you select prior to year-end.

In fact, one best practice advisors should implement is to double-check the default accounting methods that are selected at the individual account level. You should add the accounting method to your list of items to confirm during the new account set-up process. This is particularly important because you can have different accounting methods for various securities—equities, mutual funds, bonds, etc.—and these extra selections can lead to a set-up error.

We have until 2016 before complex debt instruments are included in the cost basis reporting rules. Complex bonds mainly include physical certificates, foreign debt, stripped bonds, convertible bonds and bonds with more than one interest rate. Given these different reporting requirements for the next two years, your firm needs to be ready for the confusion that can easily arise in this situation. For clients who own both types of bonds, you will likely get many questions regarding these differences.

Now that some bonds are joining the cost basis reporting rules, advisors should make sure their firm is supporting the entire cost basis reporting environment. First, ensure that your portfolio reporting system cost basis records are reconciled with your custodian’s records. Most custodians produce detailed cost basis files that can be imported into your portfolio reporting system. For many years, advisors have told their clients to rely on their records for cost basis reporting (and not the custodian’s report), which was likely good advice at the time because the advisor had a more complete record. However, now it is more important that the cost basis records match perfectly between both reports.

Since we are still in this implementation period, your clients will continue to see both “covered” and “uncovered” securities listed on their 1099 reports for 2014. Covered transactions will be reported to the IRS and uncovered transactions will not, and each year the number of uncovered securities in a client account should continue to decline (depending on the purchase date).