Beware of application of average cost

[pb4uski]

I recently sold some shares to realize some tax gains at 0% capital gains tax since I'll be in the 15% bracket this year. Prior to the sale I ran an unrealized gains report on my account (with Vanguard but I think the issue may apply to other providers as well) and my average cost per share was $30.14. Since I wanted to realize a gain of $x, I backed into the number of shares that I would need to sell to get to that gain using the $30.14 average cost and sold roughly 75% of the shares that I owned.

When I ran an realized gains report this morning, the realized gain Vanguard showed on the sale was about 25% higher than what I thought it would be and my average cost per share actually increased from $30.14 to $33.80. Using average cost, it doesn't make sense that your cost basis would increase where you sell shares - it should stay the same.

So I called Vanguard to find out what was going on.

Come to find out, Vanguard stratifies my holdings for each cusip between "covered" shares and "non-covered" shares and separately tracks the average cost for each strata. Covered shares are shares purchased after January 1, 2011 and non-covered shares are shares purchased prior to January 1, 2011. When someone sells shares, Vanguard applies FIFO to the non-covered shares and the covered shares - in other words, they sell non-covered shares first and then covered shares once all the non-covered shares are gone.

So at the time of sale my cost basis for non-covered shares was $28.65 and my cost basis for the covered shares was $33.80 and this is why the gain is so much more than what I expected it to be since the 75% sale was for all of the non-covered shares at a lower cost basis and a portion of the covered shares.

If I use Vanguard's numbers, the higher gain will put me over a target that I have for income for the year (but luckily it will not push me over the 15% bracket). They indicate that I'm responsible for reporting the cost basis of the non-covered shares so I'm considering my options.

What a mess. Does anyone have any experience with this? or am I stuck with doing it the way Vanguard did it?

 

[jebmke]

I maintain my own basis separate from fund companies. I pretty much ignore what VG reports as unrealized gains and losses.

 

[pb4uski]

I think that is what I will do. I have very good records in Quicken and use average cost in Quicken (but Quicken doesn't differentiate between covered and non-covered shares so it is truly average cost).

While I've seen minor differences between Quicken and Vanguard in the past for cost and gains/losses, this is the first time that I've seen such a significant difference.

 

[Texas Proud]

Do you have any losses you can realize to get you back down

If you have sold share in the account before and used the Vanguard report, you are officially stuck. IOW, you set that the average cost was the way you wanted to go and you have to continue with this until all shares are liquidated....

Unofficially, you can do whatever you want.... just hope you are not audited...

 

[pb4uski]

No losses - darn it!

In the past my sales/trading has been very minor so what Vanguard has reported and what I have seen in Quicken have been reasonably close so it has never been an issue.

I think I'll just use Quicken's average cost which is consistent with Pub 550. Just prior to this sale my cost basis in Quicken was 99.945% of what it was according to Vanguard, so close enough for givernment work.

 

[youbet]

Isn't there a purchase date past which your broker will/must report the capital gains to Uncle? That is, going forward we won't be on the honor system for capital gains.

 

[GrayHare]

For tax filing you can ignore a brokerage's cost basis report provided you correctly apply one of IRS-approved cost basis calculation methods instead. If your cost basis number differs from what the brokerage reported, include an explanation with your tax filing.

 

[MichaelB]

Isn't there a purchase date past which your broker will/must report the capital gains to Uncle? That is, going forward we won't be on the honor system for capital gains.

Yep. 1/1/11 for stocks, 1/1/12 for funds.

What a mess. Does anyone have any experience with this? or am I stuck with doing it the way Vanguard did it?

You can still use the average cost you calculated. Just document well. You also must continue to do so for the life of that investment. Down the road V will report a higher cost for the remaining shares and you will need to replace those with your own lower cost calculations.

 

[pb4uski]

For tax filing you can ignore a brokerage's cost basis report provided you correctly apply one of IRS-approved cost basis calculation methods instead. If your cost basis number differs from what the brokerage reported, include an explanation with your tax filing.

...You can still use the average cost you calculated. Just document well. You also must continue to do so for the life of that investment. Down the road V will report a higher cost for the remaining shares and you will need to use your own lower cost calculations.

Yes, that makes sense. Thanks.

 

[nwsteve]

Pub4uski
I second the poster who uses their own basis. I got tired of dealing with the Vanguard bureacracy this summer and moved a substantial position to Fido. (it helped that Fido offered a nice $$ incentive). All the positions were inherited several years ago and the basis reset to values at time of transfer from the estate. When Vanguard reported the basis to Fido, only about half were correct and a couple of them were materially off and did not reflect the reset at inheritance.
Nwsteve

 

[RE2Boys]

I can't speak for Vanguard as I only have IRA accounts there. Use T. Rowe Price for taxable transactions. When the law about covered shares went into effect, TRowe gave me the choice of using average cost basis or FIFO or designated lot basis. Don't know if Vanguard offers similar. I almost always use FIFO.

 

[samclem]

Long post follows--apologies.

pb4uski,
As you found out, Vanguard will sell your "uncovered" shares first. Now, here's what they told me on the phone: When you are selling "covered" MF shares (those bought after 1 Jan 2012) and you have selected the Specific Identification ("SpecID") cost basis method, their web site will show you all your purchased lots and let you pick which you want to sell. (They can't do this for uncovered shares). The system will thereafter always keep track of which shares you still own, and at the end of the year you'll get a 1099 that shows the CG based on the price you actually paid for the shares you actually sold.

If this is all correct, then it would seem that the new system will take all the "PITA factor" out of using the specific shares method--Vanguard will be keeping the records instead of us having to maintain everything ourselves. And using Vanguard's system will assure the CGs shown on the 1099 (which they'll now be sending to the IRS) matches the one you report.

So--for those who have a mix of covered and uncovered shares and who want to take advantage of Vanguard's system to start using the Specific Shares method (for greater tax savings): How to implement this? Vanguard will let us change the Cost Basis reporting method at any time, so it would be possible to change from "Average Cost Basis" to SpecID at the same time you sell your last uncovered share (the VGD web site will show you how many you own of each). But, will the IRS allow this? (see addendum below--yes they will). I thought the rule was that once you'd used the Average basis you couldn't select Specific Shares for that mutual fund holding, but in this case you've fairly "used up" all the uncovered shares and could start using SpecID with a clean slate.

Alternatively, we could just open new accounts and every share would be "covered" (since all were bought after 1 Jan 2012) and we could select "Specific Shares" from the first day. Sell from the "old" account (average shares cost basis method) when it makes sense (probably when you want a high percentage of CGs, as you and I are both doing right now while the zero% good deal lasts), or draw from the new Specific Shares account if prices plummet and we want to do tax loss harvesting.

No one should take any of this as gospel without checking things out for themselves.
***********************************************************************
Subsequent addition: This from an IRS FAQ on the new Cost Basis Reporting regs (lot sof other good info there, too):

49. When is a taxpayer permitted to revoke an average basis election or change from the average basis method?
A taxpayer may revoke an average basis election by the earlier of one year from the date of making the election or the first sale or other disposition of the stock following the election. After a revocation, the taxpayer’s stock basis is the basis before averaging. However, a taxpayer may change from the average basis method to another permissible method prospectively. The regulations do not limit the number of times or the frequency at which a taxpayer can change his or her basis determination method. Following a change, the taxpayer’s stock basis remains the same as the basis immediately before the change.
50. If a taxpayer owns shares of the same mutual fund in different accounts, can he or she make an average basis election for only some of the accounts?
Yes, but only after December 31, 2011. Prior to 2012, the regulations require that an average basis election apply to all shares of a particular mutual fund in all accounts in which a taxpayer holds the fund. Starting in 2012, a taxpayer may elect to average basis for a particular mutual fund in one account but not in another account.

I'm not quite sure how to apply Answer 49. Specifically, it's not clear how "After a revocation, the taxpayer’s stock basis is the basis before averaging" can be applied to uncovered shares (since you won't know which shares remain, and so you won't know their purchase price). But Answer 49 indicates that you could make the "transition" to the specific shares cost basis method easily and legally once you've sold your last uncovered share. In fact (see Answer 52 in the document), the IRS already considers the covered and uncovered shares as being in different accounts. And, for those still accumulating, Answer 50 indicates you can continue to use the Average Cost Basis for your old uncovered shares while setting up a separate account for your newly purchased covered shares and use the Specific Shares method for these. I don't know if Vanguard will make us establish a new account for this purpose.

Again, I'm not a tax law expert or an accountant, I'm just looking at the publications. Everyone should check for themselves.

 

[kaneohe]

some info here on "single account" election.....items 52 to 57
Cost Basis Reporting Overview and FAQs

 

[samclem]

As some recent threads here have pointed out, the now-permanent 0% LTCG rate for folks in the 15% bracket (and the favorable LTCG rate compared to other income) can be a pretty big deal. The change in reporting requirements for MF companies makes it easy now to use the Specific Shares ID method compared to the "old days"--Vanguard has a drop-down menu showing all the lots you've bought, etc. When you sell you just enter the number of shares you want to sell from each lot and you are done. The other fund companies probably have the same setup.

As mentioned in a previous post here, I was wondering how to handle the "uncovered" shares, some of which I'd sold under the Average Cost Basis rules. I bothered the helpful folks on the Fairmark site and got some good, clear help (thanks kaneohe). That discussion is at this link
for those who are interested.

As always, do your own research and consult a tax professional. But it appears that even those (like me) who formerly took the "easy out" of using Average Cost Basis can switch to Specific ID and avail ourselves of the powerful, automated features of the large mutual fund companies to assist with all the tracking. As long as I stay in the 15% tax bracket I intend to sell my appreciated "winners" often to reset their cost basis as prices rise. If prices take a dip, I'll sell some shares and harvest losses to use in reducing my taxable income (wash sale rules apply). Another tool in the toolbox.

 

[scrabbler1]

I have always used FIFO which maximizes the chance that any sale/redemption of mutual fund shares will be long-term and subject to a lower tax rate. It is also pretty easy to keep track of in my spreadsheets for each fund. I therefore ignore any cost basis information I receive from my mutual fund companies.

On my federal tax return, I specify the date range for each redemption in the 20+ years I have been reporting sales/redemptions. Never had a problem.

 

[samclem]

I have always used FIFO which maximizes the chance that any sale/redemption of mutual fund shares will be long-term and subject to a lower tax rate.

It does do that. But you give up the best chance to do "loss harvesting", right? Those of us who will now be getting in the habit of selling appreciated shares at a zero% LTCG tax rate (and re-buying them immediately) will presumably have an on-hand supply of recently "updated" shares with high basis. So, if the market "corrects" one year and shares fall by 15%, we can (after we've owned them a year--now all tracked for us by the mutual fund company and visible online) sell them and write off the loss against income (Cha-Ching!). Avoid a wash sale by either buying another fund that's not "substantially identical" or just wait 30 days and re-buy shares in the same fund. With FIFO you've got much less flexibility: The next share you sell always has to be the one you purchased farthest back. With Specific ID of shares you can be selling appreciated shares (to reset their basis to a higher level) and sell "losers" (to harvest capital losses) all in the same year. You can pick and choose from all the shares you've purchased (more than a year prior) to minimize taxes. It's no more work than FIFO (with the new info available online) and gives much more flexibility to save on taxes.

 

[kaneohe]

....... So, if the market "corrects" one year and shares fall by 15%, we can (after we've owned them a year--now all tracked for us by the mutual fund company and visible online) sell them and write off the loss against income (Cha-Ching!).

samclem..........while true, the qualifying clause "after we've owned them a year" is not necessary. You can also sell for a short term loss. Perhaps you meant this for the gains for 0% taxation in the 15% bracket which you did mention.

 

[pb4uski]

I've always used average cost in the past as a matter of convenience but that was while I was accumulating so I had few sales. Now that I am in distribution mode and my tax planning opportunities are greater, I am mulling a switch to specific identification to be able to better manage my tax situation.

 

[samclem]

samclem..........while true, the qualifying clause "after we've owned them a year" is not necessary. You can also sell for a short term loss. Perhaps you meant this for the gains for 0% taxation in the 15% bracket which you did mention.

Yes, I was thinking about assuring everything was in the same "basket" of long-term holdings, but I guess there's nothing called "short term capital losses". Thanks.

I've always used average cost in the past as a matter of convenience but that was while I was accumulating so I had few sales. Now that I am in distribution mode and my tax planning opportunities are greater, I am mulling a switch to specific identification to be able to better manage my tax situation.

This is exactly my situation. Yesterday went to the Vanguard site and switched all my taxable MFs (except MM sweep account) to "Specific ID" method of basis tracking. Easy (so far).

I think these tactics enabled by the new tracking by the MF companies/brokers (tax loss harvesting of losers, ratcheting up the basis on winners) will be staples of my regular steps to reduce taxes now and in the future. Right alongside the tIRA-to-Roth conversions I'll eventually do.

 

[pb4uski]

One thing to be sure of is that your basis and Vanguard's basis are the same before proceeding. Because I use average cost across covered and uncovered shares, for a few tickers my basis differs from Vanguard's so I'll have parallel records in Quicken that differ from Vanguard until all my uncovered shares have been sold. After that, once all the shares are covered shares they should align.

 

[samclem]

One thing to be sure of is that your basis and Vanguard's basis are the same before proceeding. Because I use average cost across covered and uncovered shares, for a few tickers my basis differs from Vanguard's so I'll have parallel records in Quicken that differ from Vanguard until all my uncovered shares have been sold. After that, once all the shares are covered shares they should align.

But you've only sold uncovered shares, and you've used the "average cost" basis for them, right? Say you changed to Spec ID right now as far as Vanguard was concerned. I think Vanguard won't be reporting any cost basis to the IRS for sales of your uncovered sales, they'll send you a 1099-B at tax time with the cost basis of these uncovered shares that assumes they were sold using the average cost basis. That's what I'll report to the IRS, since that's the cost basis I've historically used for these uncovered shares. But, as I understand it, if you also want to sell some (recently purchased, higher cost basis) >covered< shares today using the Spec ID method to tax loss harvest, you can do that, too, and the 109-B VGD sends to the IRS (and you) on these shares will be accurate reflections of the prices you paid for those exact shares.
As a backup I'll record a "snapshot" of the average cost basis of my uncovered shares in all my taxable funds as of today. That'll be the share price I'll continue to use going forward when I specifically identify these uncovered shares for sale in the future.
This use of different cost basis methods (separate for covered and uncovered shares) appears to be countenanced by IRS rules.

As usual, everyone should do their own research and consult a professional. I'm a random guy on the interwebs with no particular expertise in this stuff.

 

[MichaelB]

Here's a Q&A from the IRS that might be of interest Cost Basis Reporting Overview and FAQs One example

52. How is an averaged basis determined for mutual fund or DRP stock when some of the shares are covered securities and some are noncovered?
Beginning in 2012, the regulations treat mutual fund and DRP stock that is a noncovered security as being held in a separate account from stock that is a covered security. Because stock is averaged on an account-by-account basis starting in 2012, the basis of shares that are covered securities will be the average basis of only the covered securities and the basis of the shares that are noncovered securities will be the average basis of only the noncovered securities. However, if a broker has accurate basis information for shares that are noncovered securities and makes a “single-account election” for some or all of the shares, the shares subject to the single-account election are treated as covered securities and their basis is averaged with the shares that are covered securities.

 

[pb4uski]

But you've only sold uncovered shares, and you've used the "average cost" basis for them, right? ...

Not exactly. I use average cost across all shares (non-covered and covered shares combined - the typical application of average cost before this covered/non-covered crap started).

Vanguard uses average cost separately for non-covered shares and for covered shares. For sales, it reduces non-covered shares at average cost first and once all non-covered shares have been sold it reduces covered shares (consistent with the two separate accounts in the previous post).

For any tickers where I have sold a portion of non-covered shares my remaining basis will be different from what Vanguard shows for the non-covered shares due to the difference in approaches.

Luckily I have only a few tickers where my cost basis differs from Vanguard's and now that the 0% capital gains rate is permanent I plan to do some gains harvesting and eventually our records will align.

 

[grasshopper]

I found a big price difference in older shares of my 2 year bucket VFSUX, so I switched to Spec-ID. Everything else is covered now that I took a bunch of LTCG in 2012. I reconciled cost between Quicken and Vanguard .01 difference. Going on 4 years without touching my 2 year bucket.

 

[samclem]

For those considering more frequent selling and buying for the reasons we've discussed, another factor to consider: fund-imposed restrictions on buying after selling. For most Vanguard funds the wait is 60 days. A two-month delay on getting back into a fund will get the clock started later for purposes of establishing LTCG status.

There may be workarounds for this--Vanguard waives the 60 day restriction for some types of purchases, including:
- "Transfers and re-registrations of shares within the same fund."
- "Conversions of shares from one share class to another in the same fund."
- "Purchases of ETFs"

Of course, if we held the funds as ETFs in the first place there would be no trading restriction issue. Something to think about . . .