Investors, do you know your cost basis?

There’s one thing you really need to know about the new rules on cost basis: If you haven’t had a conversation with your broker about how you want your basis to be calculated, its time.

Cost basis is one of those topics that make all but the most hardy investors roll their eyes or go completely blank. And with good reason: It’s stupidly complicated. Not only is the cost basis itself difficult to figure out (what with splits and spinoffs and multiple purchase dates), but the tax code lets you choose among different ways of calculating cost basis that vary depending on if the security is a stock or a fund. Figuring out whether to do first-in, first-out, or specific-share identification, is enough to make your head spin, yet the amount of tax that you owe can vary wildly depending which method you choose, especially if youve been buying regularly over the years at different prices.

So what does all this have to do with the new rules? The rules state simply that your broker will have to include your cost basis (and whether your gain is short-term or long-term) on your 1099 Form starting this year. For 2011, the rule applies only to stocks purchased after Jan. 1, but over the next few years it will be phased in for other securities, including fixed income, and mutual funds.

That sounds simple, but there are two issues. First, if your securities aren’t covered by the new rule and your broker doesn’t report the basis to you, you’ll still need to figure it out yourself. And, second, even if they are, your broker is allowed to select a default method, typically first-in, first-out, for those clients who don’t choose. That means that if you don’t want the default because you’d pay more tax than you’d otherwise have to by using it you need to let your broker know before you sell any shares. Wells Fargo Advisors, for example, offers nine tax lot methodologies, including FIFO, last-in, first-out, and highest-in, first-out, for its clients to choose from. Once you receive the 1099, whatever has been reported to the IRS is what you’ll need to report on your taxes.

“The default is not necessarily the best option,” says Marisa Diaz, vice president of sales at NetWorth Services, developer of NetBasis, a software for calculating these tax-basis scenarios. “There may be a huge difference between the methods. It may even be a gain by one method, and a loss by another method.”

How big a difference could this accounting choice actually make? A lot,  depending on your circumstances. Let’s say you purchased 1,000 shares of JPMorgan stock, in the wake of the financial crisis in early 2009, at $16 a share, and bought another 1,000 shares last winter at $40. If you sold 1,000 shares recently (not adjusting the basis for our simplified example) at $46, what’s your tax hit? If you used FIFO, you’ve got a gain of $30 a share, or $30,000, and a tax hit of $4,500. But if, for accounting purposes, you sell the shares you bought more recently at $40, you have a gain of just $6 a share, or $6,000, and a tax hit of $900.

The bottom line is really the same as it was before the rules: It pays to run the numbers. After all, it may sound investor-friendly to get a 1099 with your cost basis calculated for you, but the reason the cost-basis regs were included in the 2008 financial bailout was not to help investors but rather to decrease the “tax gap” between the amount of taxes owed and those actually paid. Estimates are that this simple procedural change will raise some $7 billion in tax revenue through 2018.