Steve Burnett, the president of Sacramento, Calif.-based Hanson McClain, once went to a client's house to get some information about the stocks he held. Burnett soon discovered a most peculiar form of record keeping. In one room, hanging from wall to wall, were long sheets of paper, upon which the client, over the years, had written in pencil whenever he had sold or bought a stock or received a dividend. While astonishingly intricate, the records were essentially unmovable, not to mention nearly incomprehensible to the advisor.
Many advisors have faced the morale-damaging day when a client arrives with a sheaf of paperwork, or sometimes just a few scribbled notes, and says he needs to sell stock holdings that, in some cases, were purchased decades ago — with no other information available, not even a clue as to whether there has been a gain or a loss. The need to determine accurate cost basis on stock holdings is becoming increasingly critical; at the same time, records listing such information as when the stock was purchased and for how much are often incomplete or nonexistent. If they do exist, it require hours upon hours of labor to find the appropriate information.
“It's an absolute industry nightmare,” Burnett says. “I've seen some advisors who only like to work with cash assets for just that reason.”
A Guessing Game
The difficulty of finding original cost-basis values for stocks has vexed investors for decades and shows little signs of abating. If anything, with the number of retirees increasing and looking to cash out long-held positions, and with the baby boomer generation inheriting storied stock portfolios from their parents (sometimes as a shoebox full of old certificates), determining cost basis remains a routine and difficult task with which advisors have to contend.
Client stock inheritances, for example, are a landmine for advisors, who have to manage the impact of gift taxes on top of cost-basis issues related to the inheritance. “If there was a stock split sometime in the past, for example, that information is not realistically accessible,” says Tom Gau, with Oregon Pacific Investment Advisors. Often, advisors and clients wind up making a wild guess as to the cost basis, he adds.
At the same time, the Internal Revenue Service (IRS) is starting to make a stink about what it considers massive under-reported capital-gains taxes, in part due to inaccurate or incomplete cost-basis analysis. In a 2005 report, the IRS said there was some $11 billion in under-reported capital-gains taxes annually. There are also indications of cost basis becoming a mandated requirement: The IRS has also publicly said it may consider requiring all financial institutions to provide cost-basis information to their clients, while Congress is currently debating a bill that could require financial institutions to automatically report what the cost basis would be on each client transaction.
Yet determining cost basis doesn't just mean digging through old documents and financial records. “Cost basis is not as simple as just the price initially paid for a security,” says Joyce Rosen, product manager at the Depository Trust & Clearing Corp. (DTCC). Corporate actions are also a crucial factor, such as stock splits or dividends (and whether the client cashed out the dividend or reinvested them), she says. “The average investor doesn't keep track of all that stuff. Some don't even save their statements.”
As a response, a number of institutions are offering tracking systems that represent a quantum leap from earlier methods of determining cost-basis requirements. As late as 10 years ago, brokers often kept a sheet for each client and jotted down all stock purchases or sales. It was time-consuming and error-prone; while the trades were meant to be recorded when the buy or sell occurred, oftentimes brokers would have an employee write up the sheets, sometimes a few days after activity had occurred.
For advisors and clients, getting that information proved to be grueling. “The customer would call his broker or issuer, and someone had to do the legwork and, truthfully, often they would just provide them with statements, sometimes at a cost, and the customer still had to figure it out for themselves,” says the DTCC's Rosen.
DTCC believes it now has a solution at hand. This January, it launched what it claims is meant to be the solution to the cost-basis problem. Partnering with software firm NetWorth Services, the DTCC is funding a Web-based information service, called AccuBasis, which is meant to provide a quick and easy archive of stock information dating back to 1923. Advisors can use the service as a link on their own Web pages, so that a client can simply hit a button to automatically determine the cost basis on any security once they enter a few basics like year of purchase and CUSIP number
This new offering is building upon the DTCC's earlier efforts to improve cost-basis reporting. In 2003, DTCC subsidiary National Securities Clearing Corporation (NSCC) introduced the Cost Basis Reporting Service (CBRS), which enabled firms to transfer original cost basis, adjusted cost basis or any other cost-basis information to other firms using DTCC's Automated Customer Account Transfer Service. One of the first firms to sign up for CBRS was Wells Fargo, which put the service into operation in June 2003.
The DTCC is not alone in offering cost-basis analysis. Pershing, the largest custody/clearing firm, has been offering a portfolio evaluation service that determines cost-basis analysis to clients for the last few years. Ron Fisk, managing director of product management for Pershing, says cost-basis information has become as routine a question for client accounts as name and address. “We're trying to minimize the opportunities where cost basis can get dropped,” he says.
Unlike other problems vexing the financial industry, however, the cost-basis crisis is ultimately finite, advisors say. At some point in the next 10 to 15 years, the cost-basis crisis will be resolved, if not by legislation and technology, then by time. After all, stock trades that have been executed in the Internet age, essentially those done after 1995 or so, have an easy-to-track electronic record of trading activity. So, once the last “paper” generation of stock-owners has passed on, advisors will finally be able to cross this odious obligation off their lists.
CALCULATING COST BASIS
There are four methods to figuring out cost basis. Just remember, choosing one method over another could result in tax savings.
Method One: First In, First Out
The most basic method for calculating cost basis is first in, first out (FIFO). This approach assumes that, as you sell shares of stock, you do so in the order in which the shares were purchased. While pretty straightforward, this procedure often leads to substantial taxable gains because the longer you hold shares in a rising market, the more they're worth. No wonder the IRS assumes you are using this method unless you indicate otherwise.
Method Two: Single-Category Averaging
Another method is single-category averaging. Divide the total cost you paid for your shares by the total number of shares you own and, voila, you have your average cost basis for each share. As in FIFO, this method sells your oldest shares first. Single-category averaging doesn't take much energy to calculate, but once you begin using it to compute cost basis, the IRS prohibits switching to another method without prior approval.
Method Three: Specific Shares
Specific shares, the third way to calculate cost basis, is for meticulous investors only. If you've kept careful records of when you bought shares and how much you paid for them, you can ask a mutual fund to sell specific shares. Normally, these shares would be the ones you paid the most for, since they would generate the smallest taxable gains. But there's a catch. Gains are taxed at different rates depending on how long you've held the shares. Profits made on shares you've held for a year or less are taxed at rates significantly higher than those levied on shares held longer than a year. So consider the matter carefully before deciding to hawk expensive young shares.
Method Four: Double-Category Averaging
Finally, there's double-category averaging. Shares are divided into those with short-term and those with long-term gains and are then averaged for cost basis. Of course, different tax rates apply to each category, and you must tell your mutual fund in writing how many shares from each category you want to sell. Definitely not a process for the faint of heart.