The IRS rules for mutual fund cost basis reporting have changed effective January 1, 2012. Before 2012, investment companies were not required to report cost basis information to investors or the IRS when investors sold mutual fund shares. Investors were solely responsible for reporting their cost basis and capital gains to the IRS when they sold mutual fund shares. Investment companies that historically provided cost basis information did so at their own discretion. Now for the 2012 tax year and beyond, the IRS requires investment companies to report cost basis information to investors and the IRS when investors sell mutual fund shares. The cost basis reporting requirement only applies to mutual fund shares acquired on or after January 1, 2012. Investment companies are still not required to report cost basis information for mutual fund shares that investors acquired before 2012. The cost basis reporting also only applies to shares sold in taxable, non-retirement accounts because realized capital gains in retirement accounts are typically tax-deferred or tax-exempt.
Investors have three options for how their mutual fund cost basis will be reported. The average cost method assumes the cost of shares sold equals the average cost of all shares acquired by the investor. The first-in first-out method stipulates for the shares to be sold in the same order they were acquired by the investor. The specific identification method allows the investor to select which shares are sold regardless of when they were acquired. Investors are free to choose which cost basis method best suits their individual tax situation and even switch between the different methods with one exception. Investors who use or have used the average cost method to report capital gains or losses on mutual fund shares acquired before 2012 must continue to use the average cost method for all shares of that mutual fund acquired before 2012.
When investors sell mutual fund shares acquired before 2012, they are not required to decide on a cost basis method for those shares until they file their income tax returns because investment companies are not reporting the cost basis to the IRS. With that flexibility, investors can choose which cost basis method provides them the lowest tax burden after they have evaluated their entire tax situation for the year. That flexibility does not exist for mutual fund shares acquired in 2012 and beyond. When investors sell mutual fund shares acquired on or after January 1, 2012, they need to select their cost basis method before or at the time of sale so investment companies know which method to report to the IRS. Investors should be motivated to select their own cost basis method because an investment company's default reporting method may not provide the best tax advantage. Ultimately, the new cost basis reporting requirements should benefit investors as well as the IRS. Although more tax planning may now be required, fewer tax reporting errors should occur. Investment companies and investors are now cooperating parties in the calculation of mutual fund capital gains.
