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This Q and A is designed to help financial advisors whose clients hold Lord Abbett Funds in their portfolio better understand mandatory cost-basis reporting and how it will affect both financial advisors and shareholders.
Q1. What is mandatory cost-basis reporting?
A1. Mandatory cost-basis reporting shifts to the broker or mutual fund family the burden of computing the holding period of a security, the adjusted cost basis, and resulting gain or loss based on an investor’s selected tax lot relief methodology (See Q3 below). As a result, the reporting entity is now responsible for both computing the information and reporting it to the investor and the IRS.
Q2. Why did congress pass mandatory cost-basis reporting?
A2. Congress believes that some taxpayers who sell securities are overstating their cost basis (i.e., the amount paid for a security) and, therefore, understating gains on the sale of securities. This understatement results in the underreporting of taxable income and related taxes, and, thus, lower tax revenue for the government.
To ensure greater compliance with existing tax laws and to minimize potential lost tax revenue, Congress passed mandatory costs basis reporting as part of the Emergency Economic Stabilization Act of 2008.
Q3. What is an investor’s “selected tax lot relief methodology”?
A3. Simply put, the “selected tax lot relief methodology” is the method chosen by an investor to determine how a gain or loss from the sale of a security is computed and, as a result, the amount of taxes the investor pays as a result of the sale.
Q4. What is changing as a result of the Emergency Economic Stabilization Act of 2008?
A4. Specific changes resulting from the new mandatory cost basis reporting law will include:
Q5. When does the Emergency Economic Stabilization Act of 2008 go into effect?
A5. The Emergency Economic Stabilization Act of 2008is being implemented in three phases. The first phase relates to equity shares (stocks) purchased on or after January 1, 2011; the second phase affects mutual fund shares purchased on or after January 1, 2012; and other securities are covered on or after January 1, 2013.
Q6. Does the Emergency Economic Stabilization Act of 2008 affect shareholders who have not sold a security?
A6. Anyone who owns a security will be required to inform the broker or mutual fund family through which they hold the securities to be sold as to which tax lots they want to sell no later than the first sale of such securities. Alternatively, an investor may inform a broker or mutual fund family of their preferred tax lot relief methodology and have that method apply to all future sale transactions. Otherwise investors do not need to take any further action unless they sell a security and are preparing a tax return. Investors will receive from their broker or mutual fund family the computed net proceeds from the sale of the security, the holding period for the security, the adjusted cost basis, and the resulting gain or loss on Form1099-B and must include that information on their tax return.
Q7. What information is needed to compute gains or losses?
A7. The Emergency Economic Stabilization Act of 2008 does not change how to compute gains or losses; it only changes who (i.e., brokers and mutual fund families—not investors) computes and reports holding period information for the security, adjusted costs basis, and the resulting gain or loss to the IRS. Brokers and mutual fund families also will provide that information to the investor.
Q8. How does reporting on sales of mutual fund shares currently work?
A8. When you sell a mutual fund, you generally realize capital gain or loss. The gain or loss is computed by subtracting the adjusted cost basis from the proceeds of the sale. The adjusted cost basis typically is the amount you paid to purchase fund shares adjusted by certain items, such as a return of capital or wash sale. If the proceeds exceed the adjusted cost basis, you recognize a gain. If the adjusted cost basis is more than the proceeds, you will recognize a loss on the sale. Different rules apply to tax-exempt accounts and tax exempt investors. Your historical records (e.g., periodic account statements, transaction confirmations, prior year’s 1099s) will be the source of determining the adjusted cost basis and purchase dates. Proceeds from the sale will be reported to you on Form 1099-B by your broker or mutual fund family. Based on a combination of all this information, you must then compute the gain or loss on the sale and determine the holding period of the shares—long or short term. The holding period will dictate the maximum tax rate applicable to the resulting gain or loss. As a service to their clients, most mutual fund families, including Lord Abbett, provide shareholders with an average cost-basis statement in conjunction with Form 1099-B. This statement reflects the gain or loss and the holding period for each sale that occurred during the year by using the “single category average cost basis method” approved by the IRS. The average cost-basis statement is not filed with the IRS, and you do not have an obligation to use it.
Q9. How will reporting of mutual fund sales work going forward?
A9. When you sell a security that was purchased after the effective date (January 1, 2011, for stocks, and January 1, 2012,for mutual fund shares), you must select a tax lot relief methodology or instruct the broker or mutual fund family as to which lot of shares to sell by specifically identifying lots. A lot is created each time you purchase additional shares. Dividends reinvested also create a new lot. Lots purchased at different times and prices have a different holding period and cost basis. The tax lot relief methodology you use for shares acquired after the effective date can be different from the methodology used for shares acquired before the effective date. By February 15 of the year following the applicable effective date (January 1, 2011, or January 1, 2012), the broker or mutual fund family will send you a Form 1099-B that will indicate the proceeds, adjusted cost basis, holding period, and resulting gain or loss for each sale. You are required to use this information when preparing your income tax return; it also will be reported directly to the IRS.
Q10: How is the legislation that went into effect on January 1, 2011, affecting brokerage firms different from the legislation scheduled to take effect on January 1, 2012?
A10: Brokerage firms are required to compute and report proceeds, cost basis, gain or loss, and holding period to their clients on equity securities purchased on or after January 1, 2011, based on their client’s tax lot-selection method. Similar reporting is required for mutual fund shares purchased on or after January 1, 2012. The major difference between the two, other than the effective date, is that the average cost method for computing tax basis is allowable for mutual fund shares and generally not allowed to be used to compute cost basis of equity securities. This adds an additional element of decision making with regards to mutual fund shares.
Q11: What tax lot relief method should a client use?
A11: Choosing a tax-relief method will be an important decision that a client will need to make. Discussions and advice regarding selecting a tax lot relief method may be a differentiator between brokers, since the tax lot relief method chosen will directly impact a client’s taxable income.
Q12: What if a shareholder wants to change his/her method after he/she has already chosen one?
A12: Generally, a shareholder may change from one method to another on a prospective basis. It should be noted, however, that the selected lot must be identified no later than the settlement date of the sale. It cannot be done at year-end.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.