It's tax season -- a potentially stressful time for investors, if for no other reason than the paperwork needed to square your account activities with the IRS. Most brokers these days offer automatic downloading into tax prep programs, which streamlines the process substantially. Still, that download is only as good as the broker's records are accurate, and they sometimes get it wrong.
There are a large number of ways that mistakes can happen in tax reporting. Sometimes it's an error within the brokerage. Sometimes it's an error in the way the data gets transmitted from the investment manager to your broker. And sometimes, it's a transaction that's simply not your broker's responsibility to report -- but one you need to report anyway to square up with the IRS. No matter where the issue started, it's your responsibility to get it right when you turn in your taxes.
Issues with ordinary investments
One of the more common problems when it comes to tax reporting is the fact that not all distributions paid by investments are treated the same. Particularly with Real Estate Investment Trusts (REITs) and Publicly Traded Partnerships, though sometimes with mutual funds as well, a single cash distribution can be made up of multiple types of payments. The more common distribution types include:
- Capital gains distributions (from the sale of an appreciated asset within the investment),
- Return of capital (distribution above and beyond the investment's accounting profits), and
- Ordinary dividends (profits from operations)
Those types of investments need to get their own tax reporting correct and complete before they can tell your broker how much of your distribution falls into each of those buckets. If they send out an estimate or preliminary number and then later correct it, your broker will then pass the correction on to you and the IRS, in the form of an amended 1099. Ultimately, you'll have to match the correct treatment if you'd like to avoid undue attention from your friendly neighborhood tax auditor.
Issues with short sales
If you short sell securities, tax reporting can get quite complex, quite quickly and lead to all sorts of broker reporting issues. For one thing, a short sale is always treated as a short term capital gain or loss, no matter how long you keep the short position open. Date confusion with reporting short sales is common. A good check on the process is that if your tax software tries to assign a short sale as if it were a long term gain or loss, there's a problem in the data entry or import.
For another, if you short sell a stock and you're forced to make a payment in lieu of a dividend on that short sale, the tax treatment is different depending on how long you keep that short position open. If you close the short position within 45 days, you add the payment in lieu of the dividend to your cost basis of closing that short positon. Your broker likely won't report the basis adjustment for you. If you reach 46 days or longer on the short position, you can deduct the payment as investment interest.
Issues with options
As with short sales, options contracts can be incredibly complicated from a tax perspective, particularly if either you or the person on the other side of the trade exercises the option. As a general rule, if you're "long" an option (the one buying the option) and you don't exercise it, it's treated as either a short or long term holding depending on how long you hold the position. On the flip side, if you're "short" an option (the one selling the option) and it doesn't get exercised, it's always considered short term.
If an option gets exercised, either by you or by someone on the other side of the position, it usually starts to look more like a stock-type transaction. It can either be a buy or sell, depending on the option particulars. The general case is that if an option is exercised, the options premium (either cost or benefit) gets rolled into what you paid or received for the transaction that resulted from that exercise.
From a time perspective, the date you opened the options position no longer matters once the option is exercised. The timing and long or short term tax implications then depends on the exercise date of the option and what that exercise meant for your position with the underlying stock.
Of course, those general rules have exceptions. For instance, there are such things as with "Constructive sales" rules. If it looks like you've entered into an offsetting position to one you already have to avoid paying a capital gain, the IRS will likely consider it a "constructive sale" and require you to pay tax on it as if you had closed your original position. Similarly, there's a "Straddle rule" designed around keeping you from generating artificial capital losses one year while saving offsetting gains for a future tax year.
Even if your broker gets all the moving parts correct with the general case situations when it comes to options, it may or may not get it perfect around those nuanced exceptions. If the IRS comes knocking for you to explain your transactions and the way you claimed them for tax treatment, it won't be your broker on the hot seat -- it'll be you.
Know your investments
It's in your best interest -- and your broker's -- to get the tax treatment right for every investment you make. Still, with the complexities and nuances involved in many investment transactions, it's quite possible that mistakes will happen along the way.
Knowing how a particular transaction would be taxed before you enter into it would be an ideal way to help you double-check your tax paperwork. Otherwise, curling up with IRS publication 550 this time of year will help you deliver a far more accurate report on your investment income when it comes time to true up for your taxes.