By Kaye A. Thomas
Current as of January 3, 2015
The distinction between covered securities and noncovered securities is important to anyone who deals with the tax consequences of buying and selling stocks, mutual funds, or other financial instruments.
Brokers are now required to report cost basis and holding period in addition to sales proceeds when you sell certain items. Rules governing this requirement introduced the term covered securities.
What are securities?
Securities are stocks, bonds, mutual fund shares, and various other financial instruments such as stock options.
What are covered securities?
It’s a covered security if the broker has to report cost basis and holding period when you sell it. Shares of stock other than those purchased in a dividend reinvestment plan (“DRIP”) are covered securities if you bought them after 2010. Mutual fund shares and DRIP shares are covered securities if you bought them after 2011. Most options and bonds are covered securities if bought after 2013. (An expanded list of options and bonds will apply after 2015.) Securities other than covered securities are called noncovered securities.
- Some stock investors use a strategy that involves selling covered calls — that is, options that will allow someone else to buy shares the investor owns. This use of the word “covered” is completely unrelated to the concept of covered securities discussed here. Covered calls are covered by the investor’s ownership of enough shares to satisfy the option obligation; covered securities are covered by the basis reporting requirement.
Why is this definition important to me?
The distinction between covered and noncovered securities is important for several reasons.
Broker reporting. A broker’s tax report to you and to the IRS for a sale of covered securities will include the cost basis and holding period in addition to sale proceeds. When you sell noncovered securities, the official tax reports include only the sale proceeds. The broker may provide you with information about your cost basis and holding period for noncovered securities, but this is not a requirement and the broker won’t send this information to the IRS.
Tax returns. When you fill out your tax returns, you have to report sales of covered securities and noncovered securities separately. This allows the IRS to match up your reporting with the information it receives directly from the broker.
Separate accounts. You may hold covered and noncovered securities in the same investment account, but for tax purposes they’ll be treated as if they were in two separate accounts. Brokers apply certain rules, such as the wash sale rule, only to transactions occurring within the same account. You might have a wash sale when you sell older (noncovered) shares of stock and buy replacement shares (which would be covered). Your broker won’t apply the wash sale rule to this transaction, but you’re required to do so.
Averaging. Under the revised rules for using the average basis method for mutual fund and DRIP shares, averaging applies separately to shares held in separate accounts. Because covered and noncovered shares are treated as if held in separate accounts, you can’t average these two categories of shares together, even if they’re in the same investment account. You would maintain one average for covered shares and another for noncovered shares. In fact, you can use averaging for one category and not for the other, if you so choose.