When investors check their brokerage websites or open their mailboxes over the next few days, they're about to find out who doesn't trust them anymore: the IRS.
As surprising as it sounds, investors have long been trusted to use the honor system when it comes to reporting the size of their gains and losses to the IRS when they sell an investment.
But all that changes now, due to the passage of the Emergency Economic Stabilization Act of 2008.
For the first time, the annual tax forms investors receive, called the 1099-B, from their brokers will contain dramatic changes. Beginning with the just-completed 2011 tax year, it's up to brokers to track how much investors paid for stocks that were sold and report that information directly to the IRS. This so-called cost basis is what determines how much tax investors pay.
The changes will be a huge shift for investors, who for decades have been used to tracking what they paid for stocks. Making things even more tricky, due to some nuances in the law as well as quirks in it being the first year of the new 1099-B form, investors should brace for some surprises in the forms that brokers must mail out by Feb. 15.
"The public at large has no idea what's about to come down the pike here. They're really going to be surprised," says Nico Willis, founder of NetWorth Services, which makes software to help investors track the information.
Investors who don't want to overpay taxes on capital gains, or face penalties for underpaying, will need to be aware of some key aspects of the new rule, including:
What Investments the Changes Affect
Brokers are only required to report investors' cost basis for stocks bought on or after Jan. 1, 2011, for the 2011 tax year. Mutual funds won't be included in the new rules until the 2012 tax year, and bonds and options are included in 2013.
But some investors might still see some discrepancies. For instance, some brokerage firms might opt to report the cost-basis information on certain exchange traded funds while others may not, says Stevie Conlon at Wolters Kluwer Financial Services, which helps brokers track this type of data. Also, the same broker might report the cost basis on some ETFs but not others. For instance, TD Ameritrade, a large broker, is opting to report the cost basis on many ETFs, but not all, says the company's Becky Groves. "There's a wide ocean of securities that investors could have sold in 2011, that they are responsible for, and the brokerage isn't," says NetWorth Services' Willis.
How the Brokerage Documents Are Changing
The 1099-B investors get this year will look entirely different. It contains several new sections that provide much more detail. First, the brokerage will signal the IRS if the stock sold is one it tracked the basis for. If so, it will be called "covered." Additionally, the broker will parse the stocks sold based on if they were held short term (one year or less) or long term. It's a key distinction, because investments sold in the short term are subject to taxpayers' ordinary income tax rate, which is typically higher than the tax rate on long-term investments. The brokerage will also list transactions of shares it didn't report the basis on and didn't know how long were held.
Big Changes in Tax Forms for Investors
Investors who think the new forms will make filing taxes easier are in for a surprise, too. It's still up to investors to monitor the cost basis, for instance, of any stock bought prior to Jan. 1, 2011. Due to the new tax requirements, taxpayers also are required to fill out a new form called the 8949, which might be more detailed than investors were expecting. Not only must investors break down sales by lots, but they must also choose from three options to tell the IRS how the brokerage tracks the transaction.
Additionally, investors must mathematically reconcile any discrepancy between what they report as cost basis and what the broker reported, Conlon says. "Some say it's an 'audit me' form," she says. Also, the Schedule D, where investors have long reported capital gains and losses, is dramatically changed and now more of a summary page, Conlon says.
Possibilities for More Corrections
Investors who rush to file their returns might face having to file an amended return if their brokers make any changes to the 1099-B. Investors who in January bought shares of a stock they sold for a loss in 2011 might get an amended 1099-form that disallows that loss as a so-called "wash sale," says Cameron Routh at Scivantage. That's because brokers must notify the IRS when losses are disqualified if the shareholder buys back the losing stock in 30 days or less. Other corrections, too, might be more likely if there's any effect on cost basis, he says.
Brokers are ready for questions. "We've tried to prepare investors over the past couple of years," says Groves. But "sometimes people don't pay attention until they receive their tax form."
This story first appeared in USA Today.