Last week’s draft plan by House Ways & Means Committee Chair Dave Camp (R-MI) to reform the taxation of financial products includes two key changes that would simplify rules, reduce manipulation, minimize compliance burdens, and improve tax administration. The first would require investors to use the “mark-to-market” method of accounting for all derivatives, other than business hedges. The second would require them to use average basis to calculate gains and losses from the sale of stock or mutual fund shares, and not first-in-first-out (FIFO), specific identification, or any other method. Camp has proposed a unified approach to the taxation of derivatives: the mark-to-market method of accounting. Derivatives are contracts that are valued by reference to other assets or indices. They include swaps, forward contracts, futures, options, structured notes, security lending, and many other arrangements. The current taxation of derivatives is complicated and inconsistent. There are different rules for different derivatives, for different uses of the same derivative, and for different taxpayers. As a result, two derivatives that are economically the same may be taxed quite differently. Investors often use these tax differences to manipulate the character, timing, or source of their income to reduce their tax liability. For tax purposes, Camp would treat each derivative (other than business hedges) as if it were sold at the end of each year, and require any gains or losses to be recognized annually. Returns would be taxed as ordinary income. As a result, the taxation of derivatives would become straightforward—and most opportunities to manipulate income from derivatives would disappear. Second, Camp would require taxpayers use average basis (for each account separately) to calculate the gains and losses from their actual sales of stock and mutual fund shares. Gains and losses still would be taxed at lower capital rates and would continue to be treated as short- or long-term, depending on how long the investment is held (which is determined on a FIFO basis). Camp would eliminate the many other methods for figuring gains and losses. Currently, brokers must help taxpayers calculate their gains and losses from the sale of stock and mutual fund shares (for stock and mutual fund shares purchased on or after Jan. 1, 2011 and Jan. 1, 2012, respectively). http://www.urban.org/publications/901497.html However, brokers must accommodate customer requests for multiple methods to calculate gains and losses. For example, suppose an investor purchased 100 mutual fund shares at $10/share on Feb. 1, 2012, 100 shares for $10.50 on April, 1, 2012, and 100 shares for $11 on June 1, 2012. If the investor sells 100 shares for $12/share on Mar. 1, 2013, she could recognize $200 of gain on a FIFO basis, $150 on an average basis, or $100 on a specific identification basis (if she specified the last lot). These multiple methods encourage tax planning, undermine the simplicity of basis reporting, and confuse taxpayers. For example, for mutual fund shares, taxpayers must now decide whether to provide standing instructions to determine the order in which their shares should be sold (for example, highest basis first), whether to identify specific lots of shares to be sold at the time of sale, whether to elect average basis for their shares (separately for each of their accounts), and whether to revoke or change their average basis elections. Camp would eliminate that babel of calculations and allow only average cost basis. This would reduce complexity for brokers, cut costs, and make life simpler for investors. Customers would receive standardized reports with no confusing choices, which relatively few investors pursue (how many of you have responded to the requests by your brokers to make basis elections?). Finally, in a rising stock market, taxes are lower with average cost than FIFO. Last year, Camp tackled international tax reform. His latest proposal to simplify financial taxes is another big step forward. Next, perhaps Camp could propose streamlining tax-favored retirement plans, where savers confront well over a dozen different vehicles (Roth IRAs, traditional deductible IRAs, 401(k)s, individual 401(k)s, SEPs, etc.). The road toward tax reform will be long, but kudos to Camp for what he has done so far.