New Investor Tax Rules on the Way

Adapting to new rules for cost-basis tax reporting.

THE INTERNAL REVENUE SERVICE IN mid-December issued proposed regulations on cost-basis tax reporting. Under the measure, brokers would be required to report to the government the cost of equities sold by their customers in 2011. For 2012, they’ll have to report similar information about mutual-fund sales and, in 2013, options and fixed-income cost bases. At present, the cost basis of transactions is communicated only to clients, who are responsible for reporting it to the IRS. The comment period on the proposal ends on Feb. 8.

Investors who use online brokers have long complained to us that they have trouble getting accurate cost-basis information from the firms. So will the industry be ready in time to comply with the measure?

Even though the deadline for options is a little further off, figuring transaction costs there will be a particular challenge.

The new IRS rules will change the dynamics between investor and financial institution, says Cameron Routh, senior vice president of strategic products at Scivantage (http://www.scivantage.com). His company’s Maxit enterprise application provides real-time cost-basis and tax-based investment decision support to help financial advisors and individual investors minimize tax liabilities and increase after-tax performance. Several online brokers we cover have installed Maxit in their back offices, including TradeKing, Options- House and Just2Trade.com.

“Not only is the firm going to be reporting your cost basis to you, but they’ll also be reporting it to the IRS,” says Routh. “Some [investors] might blame the broker for reporting private info; firms are going to have to educate their customers.”

Every firm eventually will introduce its own solution. Scivantage, obviously, is encouraging its online brokerage customers to get an early jump by installing the technology that would let them meet the IRS requirements now. Routh believes that getting on top of cost-basis reporting will help retail investors, and improve the investment experience by offering pre-trade tax analysis, portfolio analysis, tax tools and other applications, to leverage cost-basis tracking.

Scivantage’s Maxit competes with Gainskeeper (http://www.gainskeeper.com), which is offered to investors through online brokers including Firstrade, Zecco and optionsXpress. Gainskeeper is also available directly to investors, who can import their transactions and run the necessary reports. Maxit doesn’t have a retail version for traders, but we wouldn’t be surprised to see one in the next year.

Frequent traders already have to report wash sales themselves. These transactions are triggered when one sells a holding at a loss, and purchases it (or something that is substantially the same, like a similar ETF) again within 30 days. The loss on the sale is disallowed, though you can add it to the cost basis of the new purchase. The changes in the IRS rules place a new burden on online brokers to track and report wash sales, including a detailed list showing each sale on a single line. Some active traders generate thousands of wash sales per year.

The complications of wash sales can lead to accounting nightmares if you have to make all the calculations on your own. Some online brokers report wash sales if you make the transactions on their Website, but the wash-sale rules apply even if, for example, you sell a stock at E*Trade and then buy one that is considered substantially the same at Charles Schwab.

Traders who opt to change their accounting method from cash basis to mark-to-market aren’t subject to wash-sale rules. But they open themselves up to a great deal of additional scrutiny. Mark-to-market traders are few in number and require heavy-duty tax software that can’t be found in the usual mass-market products. We recommend Armencomp’s TradeLog MTM (http://www.armencomp.com/gtttradelog/) for these hyperactive traders.

WE’VE GOTTEN A STEADY STREAM of reader e-mails responding to our recent plea for input about online brokers for our coming annual review. We’re still open to any thoughts you can offer.

If you’ve been using an online brokerage account over the past year, please drop us a line at electronicinvestor@yahoo.com . Thanks.

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