Among the many tax uncertainties resolved in the lame duck Congress in December was the tax rate on capital gains. Until 2013, the lower rates of 15% (and 0% for taxpayers in the lowest two tax brackets) will apply to long-term capital gains, bringing a temporary sigh of relief to investors and heading off a possible wave of selling to preserve lower taxes.

In theory, capital gains, or the positive difference between an asset’s purchase price and selling price, are quite simple. For securities in taxable accounts, a long-term gain is when the investment has been held for a year or more; gains on investments held for less than a year are considered ordinary income and are taxed at the income tax rate. (Collectibles and real estate have their own rates and rules, and capital gains do not apply to tax-deferred retirement accounts such as 401(k)’s and IRA’s.) If the net result of gains and losses is a gain, the capital gains tax rate applies; net losses can be used to offset up to $3,000 of ordinary income and can be “carried forward” to offset gains in later years. For years, brokerage and mutual firms have been required to report to the IRS all proceeds of security sales, making the “selling price” half of capital gains easy.

It is the “purchase price” half of capital gains that can be very complicated. Many investors cannot locate records of securities purchased years ago. The original purchase amount, or “cost basis”, must be adjusted when an investment undergoes a “split” in which the number of shares is increased without any change in the total investment value. Mutual fund dividends which are automatically reinvested in the fund are taxed in the year in which they are paid but also impact the cost basis, reducing the amount of capital gains when the fund is sold but making the cost calculation extremely difficult. And if an investment account transfers from one brokerage firm to another, the cost basis information often does automatically follow. No wonder that the cost basis information that investment firms provide at the end of their client year-end statements is “for information only” and not sent to the IRS, because the firm cannot be certain that the information is complete or correct.

If a sale does not include the entire investment, the investor can use several methods to identify the specific shares that were sold. Most investors use the “first-in, first-out” (FIFO) method, selling the oldest shares first, and for mutual funds the “average cost” method helps smooth out the effect of many reinvested dividends over the years. Other acceptable methods include “last-in, first-out” (LIFO), or selling the newest shares first, and specific identification, in which the investor picks specific shares for each sale to closely manage the resulting capital gains or losses.

All these variables made cost basis reporting something of an honor system, and most investors have always made good faith efforts to fairly and accurately report cost basis and capital gains and losses. As part of the Emergency Economic Stabilization Act of 2008, custodians of investment assets (brokerage and mutual fund firms) will begin reporting adjusted cost basis to the IRS on Form 1099, which also includes the proceeds of investment sales. This reporting will begin for stocks and exchange-trade funds for the 2011 tax year, for mutual funds in 2012 and for bonds and options in 2013.

Because the information on securities that were purchased in prior years is unreliable, the reporting will only apply to investments that were acquired by the investor after the effective date for that type of investment. For example, if an investor owned 100 shares of IBM before 2011 and then bought more shares of IBM in 2011, the reporting would only apply to the shares bought in 2011 or later. This means that for a number of years (perhaps many) the IRS reporting will be incomplete and cost basis will still partly rely on the honor system. The goal is to close that gap as investors buy and sell over time.

The regulations allow investors to specify the cost basis for every sale prior to the “settlement date” (three business days after a stock transaction, usually the same day as a mutual fund transaction). Custodians will be required to send and accept cost basis information for all securities that are transferred to another firm rather than sold. Unless the investor instructs otherwise, custodians will use the federally-mandated FIFO default method for stocks, and many will use the average cost method for mutual funds.

For most investors, these new regulations will likely have little effect on the capital gains they would have reported otherwise. However, reporting from custodians will be even more confusing as some holdings are subject to IRS reporting and others are not. And different custodians may implement and communicate these changes differently, adding to the confusion. On the plus side, though, these new regulations may prompt more investors to better understand their cost basis and take greater advantage of available methods when selling or gifting shares.