Noncovered Security: Definition, Reporting Rules, vs. Covered

What Is a Noncovered Security?

A noncovered security is a designation given by the U.S. Securities and Exchange Commission (SEC) which means a brokerage is not required to report the cost basis of that security to the IRS. The adjusted cost basis of non-covered securities is only reported to the taxpayer, not to the IRS. Noncovered securities are generally small and limited in scope.

However, the income from the sale of a noncovered security may still be taxable, in which case the taxpayer would need to report it to the IRS on their tax return.

What Is a Covered Security?

In 2008, Congress passed legislation which required brokers to report the adjusted cost basis for securities and mutual funds to both the investors and the Internal Revenue Service (IRS), effective tax year 2011. Since 2011, the cost basis of certain securities has been reported through Form 1099-B which indicates whether the capital loss or gain from the sale of the security is short or long term. Any transaction that occurs on or after this effective year is a covered security and is reported on Form 1099-B. A covered security is defined as:

1. Any stock in a corporation, including American Depositary Receipts (ADRs), acquired on or after Jan. 1, 2011
2. Mutual funds acquired on or after January 1, 2012
3. Stocks or ADRs acquired through a dividend reinvestment plan (DRIP) on or after Jan. 1, 2012
4. Less complex bonds, derivatives, and options purchased on or after Jan. 1, 2014
5. More complex bonds, derivatives, and options purchased on or after Jan. 1, 2016

Understanding Non-Covered Security

Non-covered securities refer to any investments purchased before the effective dates listed above. The detailed cost basis following the sale of a non-covered security is not required to be reported to the IRS by a broker. However, the gross proceeds or redemption value from a sale may still be reported to the IRS.

While a broker will still report the cost basis to the investor or taxpayer, it is up to the investor to report this information to the IRS through Schedule D on Form 1040 for any shares sold, whether covered or non-covered. Even if the taxpayer does not receive a cost basis report, they must still report their adjusted cost basis to the IRS.

Types of Noncovered Securities

Corporate actions, such as stock splits, stock dividends, and redemptions, usually result in additional shares for the investor. The additional shares will be classified as noncovered if they were received through noncovered shares.

For example, an individual who bought 100 shares in a company in 2010 that split three-for-one in 2013 will receive an additional 200 shares. Even though the 200 shares were acquired after 2011, they are considered non-covered because they were split from shares acquired before 2011.

A dividend reinvestment plan (DRIP) allows an investor to reinvest his dividends for additional shares in the same company. An investment security that was purchased in 2011 but transferred in the same year to a DRIP that uses the average cost method of calculating the cost basis for an asset is a non-covered security. But if the transfer occurred after 2011, it will remain a covered security.

Investment sales are divided into covered and non-covered securities using Form 8949. Transactions on non-covered securities not reported on Form 1099-B are reported on Form 8949 where Code C (box C checked) is used for short-term holdings, and Code F (box F checked) for long-term holdings.

The Bottom Line

A noncovered security is an SEC designation indicating that a broker does not have to report the cost basis of that security to the IRS. This is generally for smaller securities. Securities created from noncovered securities, such as stock splits or DRIP accounts, remain noncovered.

The brokerage still reports the cost basis to the taxpayer, and if the taxpayer sells the security, the basis and any gains or losses must be reported to the IRS on IRS Form 1040, Schedule D. IRS Form 8949 is also used to report investment sales of both covered and noncovered securities.