I first asked about this in 2011, when the "covered" vs "non-covered" reporting legislation came into effect. It seemed clear that I needed to divide my transactions into two bins, one for "non-covered" and one for "covered" going forward. But, I never did so since I hardly sold anything in a taxable account. Now for 2020 tax season this is biting me big time:
Remember, even if you use the average cost method, the mutual fund companies all seem to calculate two different bases - one for "non-covered" (pre-2012) shares and one for "covered" (2012 and later.) For example:
2010: Buy 100 sh XYZZX at $10 (non-covered)
2015: Buy 100 sh XYZZX at $30 (covered)
2020: Sell 100 sh XYZZX at $50 (will be non-covered shares, the non-covered bin is emptied first)
2021: Sell 100 sh XYZZX at $50 (will be covered shares)
They are going to report your sale from the uncovered bin first - so the basis for your 2020 sale will be $1000, for a $4000 gain. For 2021, the shares are covered; they will report a basis of $3000 to the IRS and a $2000 gain.
If you mistakenly combined both purchases into the same bin and calculated the average basis, you might be tempted to report each of the sales with a $2000 ($20 per share) basis. Since the 2020 sale is not covered, you might report a $2000 basis for it, for a $3000 gain, which the IRS won't know about. But for 2021, you will also need to report a $2000 basis, for a $3000 gain, which is different from what you will get on your 1099-B. This could get you a letter from the IRS.
For some reason how this two-bin basis calculation works is not documented or explained anywhere online, or by any of the fund companies' tax guides. Best bet: just assume that all the numbers on your 1099-B are right, even for non-covered shares you have had a long time. You might want to break out non-covered vs covered bases now, before you exhaust your un-covered shares. Those can probably be fudged a little, as log as all the bases you have used for all the sales in each bin add up to the amount that you paid in to the fund.
Another way is to use FIFO or some other method. In retrospect, that might have been easier than average cost.
Comments
Numbers in 1099-B form should be accurate https://investor.vanguard.com/taxes/cost-basis/covered-noncovered
https://www.irs.gov/publications/p550#en_US_2019_publink1000250005
If one uses average basis, there is no choice in which shares were sold. They are sold oldest first.
If one uses what the IRS calls "cost basis", i.e. actual cost of the shares, then one must say which shares one is selling and for each of those shares state its cost basis (actual cost). It doesn't matter whether those shares are covered or noncovered, their cost basis is what you paid for them. Pretty straightforward, unless you previously sold some shares using average basis.
There are three ways to state which shares you are selling:
- By enumeration - stating explicitly which shares you're selling,
- Algorithmically - giving a rule to enumerate the shares, e.g. highest cost first (HCFO), or
- Oldest first (FIFO) - this is just the default algorithm that's used if you didn't specify a different algorithm. So in a sense it isn't even a third way of saying which shares you're selling.
Where things might get a bit tricky is where, as @BenWP did, you sell some shares using an algorithm to enumerate those shares, and then later sell more shares. You have to know which shares were sold previously to know which shares you've got left now to sell.At least you have a paper trail of the shares you sold previously, because you had to report that on your 1040 when you sold them. So just cross them off your list of shares and whatever is left is what you're able to sell going forward.
To reiterate, covered vs noncovered has no effect on basis if you are consistently using cost basis (actual cost) and not average basis (average cost).
It is worth commenting on the suggestion that "a fund or brokerage must continue to use the average price method if the client has used that method previously."
For covered shares, " A taxpayer may change basis determination methods from the average basis method to another method prospectively at any time."
26 CFR § 1.1012-1(e)(9)(iii)
https://www.law.cornell.edu/cfr/text/26/1.1012-1#e_9_iii
For noncovered shares, the fund company does not report costs to the IRS. So it doesn't matter what it thinks your costs are. Further, the fund company does not know what method you elected to use when reporting gains from noncovered shares on your tax return.
https://fairmark.com/investment-taxation/capital-gain/selling-mutual-fund-shares/electing-a-cost-basis-method/
What is true is that the taxpayer must continue to use average basis on the noncovered shares unless granted permission by the IRS to change methods.
The "mutual fund bifurcation" is correct, but it doesn't explicitly say whether it's IRS rules or convention the require it. One I redo the calculations that way, it's clear that that is what all my funds are doing: oldest shares are sold out of the noncovered bin first, until they are all gone, then the covered shares are sold. I'll just assume this is required by IRS rules.
For years I've just been keeping track of my average basis using a single bin. I've only liquidated two funds since the bifurcation rules started, and my results vs the funds have only been off by a few cents.