Reply To: Question on cost basis for mutual fund sale on noncovered shares

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#1339
Kaye Thomas
Moderator

To begin, there is some ambiguity as to whether your initial sale validly used the average basis method. At that time, there was no such thing as a mutual fund default method. Many mutual funds, as a convenience to their customers, provided average cost information at the time of the sale, but the default was separate basis, and according to the regulations, you had to attach a statement to your return affirmatively electing an average basis method if that is what you intended. Few people understood this, so most taxpayers who received average basis information from mutual funds reported their sales using average basis without attaching the statement required by the regulations. The IRS never enforced the requirement to attach a statement, so as a practical matter everyone who used average basis on a tax return was treated as having made a valid election. Given this state of affairs, there are pretty good arguments on both sides of the question whether you’re bound by the average basis method you used on that first sale.

Assuming we are to treat the election as valid, the rules in effect at that time said the election shall apply to all shares held by the electing taxpayer on or after the first day of the first taxable year for which the election is made, and the election may not be revoked without the prior written permission of the IRS. That language seems to preclude you from using approach (a) in your question. There’s no apparent policy reason against permitting that approach, but the regulations are pretty clear in saying it is not permitted, except in the case where you request and obtain a private ruling from the IRS.

You could, however, take the position that having failed to make an explicit election of average basis method, you aren’t bound by that method. You can’t take inconsistent positions as to the basis of the shares held at the time of that sale, so the practical way of dealing with those shares is to apply the average basis method to any shares that remained unsold as of that date, but then (because no election has been validly made) use separate basis for any shares acquired afterward. In other words, use your method (a), not because it is a permitted approach, but because it is a reasonable, good faith method of dealing with the fact that you failed to make an effective election at the time of your earlier sale.

Audit activity with regard to basis reporting in sales of securities has always been pretty close to zero, which is the reason for the broker reporting requirements. You should be able to sleep well after using either of these approaches. Understand, though, that in using (a), you aren’t doing something that is permitted by the regulations, but dealing in a reasonable way with an error made on a previous sale, where you used average basis without having met the formal requirements for electing that method.