Brokers and mutual fund companies are now required to report your cost basis and holding period in addition to sales proceeds when you sell shares. The requirement doesn’t apply to all shares, however. What’s more, even when they follow all the rules, brokers may report incorrect figures. Taxpayers can’t rely blindly on these reports.
Why reports are incomplete
Cost basis reporting requirements apply only to covered securities. For stocks this generally means shares purchased after 2010; for mutual fund shares and stocks held in dividend reinvestment plans it means shares purchased after 2011. When you sell older shares, the broker’s official report includes only a description of what you sold and the sales proceeds — not the cost basis and holding period.
In the rest of this article the term “broker” includes other reporting entities, such as mutual fund companies.
Your broker may provide supplemental information about when you bought the older shares and the amount you paid. The quality of this information may not be as strong as the officially reported figures for covered securities, however.
Corporate transactions. For covered securities, brokers are required to make adjustments to cost basis when required due to certain “corporate transactions” such as stock splits, mergers and spin-offs. As a practical matter it isn’t possible for brokers to go back in time and make these adjustments for all the noncovered securities held by their customers. If you treat the original purchase price of your older shares as the cost basis, you may be omitting an adjustment that’s required because of one of these transactions.
Wash sales. If you buy replacement shares within 30 days before or after selling shares at a loss, the wash sale rule prevents you from claiming the loss and also requires an adjustment to the basis and holding period of the replacement shares. Brokers are required to apply the wash sale rule when you sell covered securities but not when you sell noncovered securities. If you made any wash sales before the rules went into effect, your original cost and purchase date for the replacement shares won’t accurately reflect the basis and holding period.
Supplemental information from your broker concerning sales of noncovered shares may provide valuable assistance in preparing your return, but it’s less reliable than the official reports for sales of covered shares.
Official reports can be incorrect, too
Unfortunately, even the official reports for covered securities won’t necessarily reflect the correct basis and holding period, even if your broker followed all the rules.
Some rules not applied. For various reasons, brokers are excused from applying a number of rules that can affect the basis and holding period of your investments. They don’t have to apply the straddle rules, for example, which can affect your basis and holding period for stocks when you buy and sell options on the same stocks. If you receive shares as a gift, your broker isn’t required to adjust the basis for gift tax paid on the gift.
Wash sales. More importantly, brokers apply the wash sale rule only when the sale and the purchase of replacement shares both occur in the same account, and for purposes of this rule, covered shares and noncovered shares are treated as being in separate accounts, even if they’re in the same investment account. This “same account” rule applies to your broker, but it doesn’t apply to you: the IRS requires you to apply the wash sale rule even when you buy replacement shares in a different account from the one where you made the sale.
This limitation on the way brokers apply the wash sale rule can have far-reaching consequences. If you sell noncovered shares at a loss and buy replacement shares within the wash sale period, the replacement shares will be covered securities because you bought them after the cost basis reporting rules took effect. You’re required to apply the wash sale rule and adjust the basis and holding period of the replacement shares. Your broker won’t apply the wash sale rule and therefore won’t make this adjustment. When you sell these replacement shares, perhaps years later, the broker will report an incorrect figure for cost basis to the IRS.
It’s possible that the basis adjustment for an earlier wash sale will make the difference in determining whether a later sale of the replacement shares produces a gain or a loss. In that case, the broker may fail to detect a later wash sale, even though it involves a sale of covered securities.
And here’s another problem. If an undetected wash sale involves mutual fund shares for which you’re using the average basis method, the basis of all your shares of that mutual fund will be incorrect. You’ll have to account for a discrepancy on all subsequent sales of shares from that account until you no longer own any of that mutual fund.
Complete and correct tax reporting for your investment transactions is your responsibility. You have to supply any information missing from your broker’s report, and make any necessary corrections to the information the broker provides. Broker reporting of cost basis and holding period goes a long way toward solving this problem, but taxpayers still need to maintain records and comply with the rules as they apply to individuals rather than the more limited rules that brokers are required to apply.