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Tax Consequences of Sales and Cost Basis for Stocks, Mutual Funds and Fixed Income Securities

Why are brokers reporting cost basis to the IRS?

The U.S. General Accounting Office (GAO) estimated that during 2001 taxable income was under reported by $11 billion because taxpayers used the incorrect cost basis for securities sold that year.  The GAO estimated that almost 38% of the taxpayers who reported the sale of a security in 2001 had misreported their taxable gain or loss. As a result Congress passed a law requiring brokers to report the cost basis of certain securities to both the IRS and the taxpayer whenever a sale takes place.  The reporting requirements are being phased in over the following years:

  • January 1, 2011 – Stocks and other equities
  • January 1, 2012 – Mutual funds and dividend reinvestment plans
  • January 1, 2014 – Less complex fixed income securities consisting of: treasury notes and bonds, fixed-rate corporate bonds and fixed-rate municipal bonds
  • January 1, 2016 – More complex fixed income securities, some examples of which are: variable-rate bonds, step-rate bonds, convertible bonds, stripped bonds, etc.

For any of the various types of securities listed above that were purchased after the applicable effective dates brokers are required to track the cost basis of the securities. When the securities are sold brokers are required to report the sales proceeds and the cost basis to the IRS on Form 1099-B. On the Form 1099-B these securities are referred to as “covered securities” meaning that the broker is reporting cost basis to the IRS. For securities that were purchased before the applicable effective dates the broker will only report the sales proceeds to the IRS. These securities are referred to as “noncovered securities” for which the taxpayer is responsible for determining the cost basis to calculate the taxable gain or loss.

Taxpayers should have received Form 1099-Bs reporting proceeds and cost basis for any “covered securities” sold in 2013.  The calculation of cost basis for stocks and mutual funds are fairly straightforward, with the basis generally being the purchase price. The calculation of cost basis for fixed income securities is more complicated, depending upon the type of fixed income and whether it was purchased at a premium or discount.  If you sold a less complex fixed income security in 2014 that was purchased after January 1, 2014, you will see the cost basis for that security on your Form 1099-B that you should receive sometime in February 2015. In order to help you understand how this cost basis is calculated the following is a list of the most common types of less complex fixed income securities and an explanation of how cost basis is calculated for each.

Taxable bond purchased at a Premium

If a bond pays taxable interest, you are allowed to choose whether or not to amortize the premium.  If you amortize the premium, each year you will subtract a portion of the premium from your interest income for the tax year. For example, if you bought a bond on February 1, 2012 for $110,000 and the bond pays its principal amount of $100,000 on February 1, 2019, your bond premium is $10,000. For the next seven years you will reduce your taxable interest income by a portion of the $10,000. The portion will be calculated based upon the “constant yield to maturity” (CYM) method.  You will also reduce your basis in the bond by the same amount each year. When the bond matures and you receive the $100,000 of principal and your cost basis in the bond will be $100,000.

If you had elected to amortize the premium in 2012, you had to attach a statement to your tax return letting the IRS know that you elected to amortize and this election was binding for all taxable bonds that you own for all subsequent tax years. Most brokers have default reporting systems that amortizes the premium over the period of the bond, but you could elect to have your broker turn off the amortization function. If you elected not to amortize the premium, then you will have a capital loss of $10,000 when the bond matures in 2019.

Taxable bond purchased at a Discount

If a bond pays taxable interest, you are allowed to accrue the discount over the period of the bond or you can treat the gain as ordinary income in the year you sell the bond or the bond matures. If you bought the same bond as in the above example, except that you paid $95,000 instead of $110,000 for the bond, you would have a discount of $5,000. You could accrue the $5,000 over the seven years by including a portion of the discount in interest income each year based upon the CYM method.  You will also increase your basis in the bond by the same amount each year.  When the bond matures in 2019 and you receive the $100,000 and your cost basis will be $100,000. If you do not accrue the discount, you will have ordinary income of $5,000 when the bond matures. Most brokers have default reporting systems that accrues the discount over the period of the bond.

Tax-Exempt bond purchased at a Premium

If you buy a tax-exempt bond at a premium, you are required to amortize the premium each year over the period of the bond. Because the bond pays tax-exempt interest you cannot deduct the annual amortization amount from your taxable income. As an example, you bought the bond for $11,000 and it will mature in five years at $10,000. You will amortize a portion of the $1,000 each year during the five years using the CYM method. Upon maturity the cost basis is equal to the proceeds received, so you have no gain or loss.

Tax-Exempt bond purchased at an Original Issue Discount (OID)

If you buy a tax-exempt bond at an original issue discount (OID), you are required to increase the basis of the bond each year over the period of the bond. If you hold the bond to maturity the OID will accrue each year and be treated as tax-exempt interest.  For example, you bought the bond at an OID of $9,500 and it will mature in five years at $10,000. You will accrue the $500 using the CYM method over five years and at maturity the cost basis is equal to the proceeds received.

Tax-Exempt bond purchased at a Market Discount

Market Discount, unlike OID, is not treated as tax-exempt interest when recognized because it arises as a result of market forces, not through the action of the issuer. When you purchase a tax-exempt bond after its original issuance for a price less than its stated redemption price at maturity, and you have a gain on the disposition, part or all of the gain will be treated as ordinary income. For example, the tax-exempt bond was originally issued at par of $5,000 on January 1, 2008 with a twenty-year maturity. You buy the bond for $4,400 on January 1, 2013. If you sell the bond on January 1, 2018 at a price of $4,700, one-third (5 years of owning the bond divided by 15 years from purchase to maturity) of the market discount would have accrued. The $200 (1/3x $600) of market discount that accrued would be treated as ordinary income. The remaining $100 of your gain would be taxed as long-term capital gain.

Who is responsible for keeping track of the cost basis of fixed income securities?

Prior to January 1, 2014, you (the taxpayer) were required to track the cost basis for any fixed income securities that you owned so that you could accurately report the gain or loss upon a sale or maturity. Your broker is required to track the basis of any fixed income security that is purchased after January 1, 2014, and held by the broker on your behalf. The broker is required to report the cost basis to the IRS for any fixed income security that you sold, if the security was purchased after January 1, 2014.

What are the changes that Schwab will implement to meet the new reporting requirements?

In August 2014, Schwab made changes to its amortization settings in its cost basis system to conform to the new IRS reporting rules. The changes will be retroactive to January 1, 2014. These changes will affect all open bond holdings in your accounts. Listed below is a summary of the changes:

  • Amortization settings will be turned on for all accounts
  • The methods used to calculate amortization and accretion will be updated depending upon whether a bond is purchased at a premium, OID, or market discount, and/or if there is a call or put feature.
  • Market discount on a bond purchased on the secondary market will be calculated using the straight-line accounting method (this is the same as the IRS default for taxpayers).
  • The amount of the market discount will not be included into current income or adjusted cost basis until the position has been sold, has matured, or has been called. Prior to this change, Schwab assumed that you included market discount in your current income and adjusted cost basis daily.